The Power of Triple Witching

Everyone has blamed the selloff on a hawkish Fed even though they went through with another 25 bps rate cut.  If you look at the price action, it seems to make sense, but then you look at the elephant in the room, that no one notices.  Its the options market, and in particular the SPX, which controls a huge amount of the the market's total notional exposure.  This is especially pronounced during the 4 quarterly expirations coinciding with the futures expiration, well known as triple witching expiration.  The hedging and systematic positions that get built up are disproportionately focused on those 4 expirations in March, June, September, and December.  Of the 4, December is by far the biggest, which can often lead to large outsized moves around the quarterly expirations, when they are unexpected.  

Coming into the FOMC meeting last week, the market was grinding lower slow, but with very little volatility.  And with FOMC meeting days having a bullish bias all year, it appears a lot of hedgers decided to delay their annual rollover of put buys/calls sells for 2025 into the latter part of last week, after the FOMC.  Also a lot of fast money momentum traders were probably looking to exit late last week after what they thought would be the start of the Santa Claus rally.  Well when you have an elephant (SPX hedgers) try to exit along with a bunch of fast money bulls at the same time, you can get violent down moves like you saw last Wednesday.  

Last week's move doesn't change my outlook at all for 2025.  These sudden sharp drops are just a symptom of a market that is saturated with long positions, with few discretionary traders left to buy when there is a dip.  The vol control funds had gotten back to near max long positioning.  The biggest trend following ETF, DBMF, increased their SPX positioning to the largest of the year.  At last check, they are holding a $556 million long position in SPX futures, with a total net asset value of $1,237 million.  They are nearly 50 percent long their fund in SPX.  Not to mention they are long over $200 million in MSCI and MSCI emerging market futures, making them net long 62% equity index futures. That is a huge long position for them.  All of the systematic funds were back in the pool as of early last week.  It may be a different picture today, but I doubt it.  It takes most of these trading systems several weeks to go from net long to neutral, and a few weeks more to go from neutral to net short.  

Was it a coincidence that once the SPX quarterly options expired on Friday AM at the open, the market shot up over 100 points?  The CNBC Fast money crowd will credit the PCE and whatever Fed talk happened that day with the move, but it looks like the options market was a huge driver of the price action from Wednesday to Friday.  

The force that options are having in this market reminds me a lot of 2021, when you had rampant speculation in short term calls.  Just like the past 2 monthly options expirations, you had lots of selling around the options expiry.  A lot of it due to call selling from the speculators who don't have the funds to exercise their ITM options, thus being forced to sell before they expire.  You see a big drop in the open interest after these expirations, and with much more call activity than put activity, it leads to a lot of net deltas that come off the dealer's books, forcing them to sell their longs which they used to hedge their short call positions.  These options dynamics are a symptom of call options speculation run amok.  

By last Thursday, you did finally see the put activity increase as investors go nervous and the volatility increased.  The ISEE index plunged on Thursday and Friday, back to levels not seen since the Monday ahead of the 2024 election.  

While we don't have the COT data from Wednesday to Friday, we did see asset managers reduce their net long positions, although small specs remained heavy long. 

I would assume that the asset managers pared back a lot more of their long positions into the weakness from Wed. to Fri., as they are usually trend followers.  We'll know for sure in next week's COT report.  

Given the intense selling and prices getting close to 5800-5850 strong support, I did some buying of SPX on Thursday and Friday.  With the exaggerated moves due to opex and time-sensitive sellers last week, I expect that to setup for a Santa Claus rally this week.  We already saw part of that start on Friday as soon as those SPX AM options expired.  Looking for a further rally as we enter a very seasonally positive part of the year, along with big capital gains held by most investors.  These investors will likely to be very reluctant to sell for the remainder of the year, in order to delay their capital gains tax hit for 1 more year.  It probably means that whatever selling that was delayed for tax reasons will likely hit the market hard in early January.  

Big picture, I remain bearish on stocks, as there are numerous signs of long positioning being saturated, and with asset managers unwilling or unable to increase their net long positions much further from here.  Volume will go down a lot this week, and low volume markets usually favor the long side.  The urgent sellers did their selling late last week, so that should give room for a healthy bounce this week, to potential resistance around 6050-6090.