Traders Brace for Stock Market’s Last ‘Liquidity Window’ in 2020

(Bloomberg) — In a year that’s seen the market bombarded by wild swings and violent rotations, traders are facing their last, if not best, opportunity to adjust positions on Friday before things slow down for the holidays.

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Options and futures on indexes and equities are scheduled to expire, a quarterly event known as quadruple witching that typically fuels trading as large derivatives positions roll over. While spikes in volume usually occur around the open and close, providing windows of robust liquidity, large price swings can happen suddenly at any time of the day.

Coinciding with the event is Tesla Inc.’s widely-watched inclusion in the S&P 500, a development that alone is estimated to force roughly $80 billion of stock trading. While all the turbulence means headaches for traders, some market watchers view it as the final chance for investors to shuffle big holdings before liquidity thins out into Christmas and the New Year’s holidays.

“Traditionally these are outsized liquidity days, and following the rebalances we expect liquidity to dwindle into year-end,” Wells Fargo & Co. strategist Chris Harvey said. “In other words, Friday is likely the last opportunity to make major portfolio shifts before the 2020 liquidity window closes.”

© Bloomberg Quadruple witching spurs trading volume in stocks

More than 90 million option contracts are set to expire Friday, up 24% from a year ago, according to data compiled by Chris Murphy, a derivatives strategist at Susquehanna. The increase reflects continued call buying especially from day traders chasing single-stock upside, Murphy said.

Animal spirits are running hot in the option market. On average, about 19 million call contracts have changed hands this quarter, a record high. The Cboe equity put/call ratio, tracking trading volume in bearish versus bullish options, has seen its 10-day average hovering near the lowest level since the internet boom in 2000.

© Bloomberg Calls are all the rage in the options market

Investors are seeking quick profits via risky bets in a market in which the S&P 500 has rallied more than 10% this quarter amid hopes for a return to normal economic activity. Bolstered by vaccine news and a clear-cut presidential election, stocks once ignored by investors, such as energy and small-caps, are coming back in vogue, replacing technology as market leaders.

While retail investors have continued to be active in the single stock names, often trading call options on popular technology companies, professional money managers are increasingly turning to sector exchange-traded funds to position for broader market gains, according to David Silber, head of institutional equity derivatives at Citadel Securities.

“In the institutional space, you began to see a bit more fundamental positioning, perhaps even away from some of those more technology-focused names and work-from-home type names that have had very large moves this year,” he said. “Upside calls on the Energy Select Sector SPDR Fund, for instance, have become popular, along with other sectors that might benefit from a change in administration, vaccine-driven economic reopenings and a continued low interest rate environment.”

While trading activity is bound to rise Friday, the impact of quadruple witching on the market’s overall direction is not easy to predict. One way to examine the event is through the lens of options dealers, who typically need to hedge their positions by buying or selling underlying stocks. Their holdings are often scrutinized to gauge the potential impact, with “long gamma” indicating they’re pushing against the prevailing trend while “short gamma” points to a tendency to go with the trend.

To Charlie McElligott, a cross-asset strategist at Nomura Securities, S&P 500 futures are likely to be stuck between 3,750 and 3,700, levels that correspond to two “big gamma strikes.” After the event, gamma-related equity exposure that’s linked to the S&P 500 could shrink by 38%, opening the door for a broad range of movement next week for the benchmark index, he said.

“With a market exposed to many moving parts, the normally quiet holiday weeks may be punctuated by some fascinating aftereffects,” said Steve Sosnick, chief strategist at Interactive Brokers.

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