As we approach the Quarterly Options Expiration (OpEx) for Index options many social media accounts are hard at work peddling their analysis of what we can expect. Of particular interest to them is the large JPM fund collar trade that is due to be rolled over at the end of December.
This is a trade entered into by a JPM fund where the fund simultaneously sell out-of-the-money (OTM) call options and buy OTM put spreads (buy an OTM put and sell a deeper OTM put). They trade options that expire at the end of the quarter and (currently) repeat the trade for every quarterly expiry options. Option liquidity providers take the other side of the trade.
Due to the size of the trade (around 40,000) this has become an easy trade to spot. Not wanting to miss the bandwagon, options insight accounts have been falling over themselves to tell us why this trade is so important and what it will do to the markets. They have gained a lot of publicity by doing so.
The Initial Mistake
In their quest for ‘likes’ and publicity, many of these accounts have already been caught out making some huge, yet basic errors in their analysis of the trade.
It was around this time last year that some of the options ‘experts’ were claiming that the rollover of this trade would lead to huge activity in the underlying market as option market makers would need to rehedge their position. This analysis was wrong. The new trade is completed in what is called a ‘delta neutral’ way – meaning that the market maker’s hedge is included as part of the trade by the client (JPM fund).
The fact that the ‘experts’ made such a basic error should be a warning sign as to their real knowledge. But the reality is that the errors keep coming.
Misunderstanding how options market makers operate
As we approach the current OpEx and rollover of the JPM trade, the ‘experts’ continue to make another significant error in their analysis. An error that, if they had real knowledge and insight into how market makers operate, they wouldn’t be making.
We are currently being told about the large Gamma exposure of the option market makers leading into expiration due to their exposure to the JPM trade. The closest strikes to the current Index price are said to heavily influence the underlying Index and are being closely watch by the various ‘experts’.
The (big) mistake these accounts are making is that they assume the market makers still have the same exposure to the JPM strikes now as they did three months ago. They mistake the fact that Open Interest is still large for these strikes with a misguided belief that this means the original liquidity providers are still on the other side.
It is highly unlikely that the market makers have anywhere close to the original exposure to those strikes. Let’s find out why.
How option market makers really operate
Like any market maker, options market makers want to get out of as much risk as possible as quickly as possible. Options have various risks and market makers will try to reduce these to the minimum. These risks include:
- Volatility risk – Vega
- Direction risk – Delta
- Change in direction risk – Gamma
- Strike risk
Delta risk is almost always hedged immediately . The others can be reduced/eliminated over time as the market maker trades. The large option market makers run algorithms and programs to help their price setting while also helping to reduce the risks outlined above.
Vega and Gamma risk can be reduced by trading any option of any strike and maturity. As for strike risk (the risk of having too large an exposure to a certain strike), this can be reduced through trading options of the same strike but either for slightly different maturities or for weekly, monthly etc versions of the same or similar options.
What the ‘expert’ insight accounts seem to forget is that there are many different types of options and the market makers will trade in all or at least most of them. For example, for the S&P500 Index there are SPX, SPY and ES options and these include weekly, daily, monthly and quarterly options. There are also the various individual equity options some of which will have a high correlation to the Index. Market makers can spread or reduce their risk across any of these.
We should also remember that the market maker will trade in and out of the JPM strikes, thousands of times between the original trade and the expiration three months later. Further, if any of the strikes became ITM or At-the Money (ATM) during their life, it would be even easier for the market maker to reduce strike risk.
So the strike risk from the JPM trade has by now, been spread across multiple participants in multiple markets.
Therefore, the current exposure of the original liquidity providers to the JPM strikes will be nothing like what it was originally. But because of the way Open Interest is calculated, it will remain high after the market makers have traded out of the options to another trader.
JPM – A passive Player
The main reason why Open Interest remains high for these strikes is because the JPM fund that instigated the trade, continues to hold it. However, the fund is a passive player in terms of all they do (so far) is hold the collar trade and then at expiry buy the next one. Whether or not the underlying Index is trading around the strikes of their trade makes no difference to them. The options trade is just a hedge for their fund.
So while Open Interest is large for these strikes, I would suggest that this option trade will have very little influence on the underlying market leading into OpEx.
Another WTF moment
When I read some of the analysis of the options ‘experts’ I so often have to ask myself, how can they be so wrong?
In this example, to assume that the market makers have the same exposure to a strike, three months after the original trade is simply astounding.
It doesn’t just demonstrate a lack of knowledge of option market makers, it shows a poor understanding of markets and market makers in general.
It has long been commonplace for sell-siders to look for option strikes with high Open Interest close to expiration and claim these will drive the underlying but in reality, the relationship is far more complex.
As always we should be wary of such simplistic causation narratives and understand the context of what is happening.