FOMO and Option Flows: What is moving markets ?

On the back of my previous posts regarding the impressive market volatility (intra-day & close-to-close), and 0DTE options (zero-day-to expiry daily options), I wanted to discuss the unstable bear market rallies that we continue to experience, and how the options market is quite often fueling these market moves with a spot-up-vol-up, and conversely, a spot-down-vol-down dynamic. For those who are familiar with volatility, this is quite unusual as volatility typically spikes when spot declines, and vice-versa.

If you look at the SPX chart above and think about the idea of these sporadic market rallies, the most significant occur either in the context of bear markets such as after the COVID crash of March 2020, or, and in a lot of cases, during the several sell-offs around OP-EX (options expiry). In these instances how can we explain what is really happening ? Well, as we are “fed” some form of good news (no pun intended), the market rallies and we are all buying high levels of stocks and call options chasing the market higher due to FOMO, and as a result of the increased long delta positions we see implied volatility (IV) going up as well (spot-up-vol-up). Unfortunately, when this happens IV becomes very stretched and unsustainable. Consequently, IV becomes too expensive where you can no longer buy those call options at where the valuation is, the mechanism turns and feeds back on itself, and leads to a spot-down-vol-down scenario as those long delta positions are unwound. This spot-up-vol-up and subsequent spot-down-vol-down market dynamic continues in a loop and is pretty much what we have been witnessing for several months while the market doesn’t really go anywhere.

If we look at some specific single stocks such as Gamestop (GME) (chart above) and Carvana (CVNA) (chart further below) the positive payoff for buying calls when IV is high becomes less likely as spot and IV continue to go up. Yes, it is possible that the meme-stock retail traders congregate together to push spot another 20% higher tomorrow, but if it does then guess what ? IV is going to jump even higher and be even more unsustainable. As an example, buying calls on GME at an IV of 133 (its peak over the last few months), you literally would not be able to make any profit on the position, however, if you wanted to sell a put you could have sold a 50 strike put for about $49 dollars when GME IV was way up around 300 further back in the year. Here, you would have been guaranteed to make money unless the company goes bankrupt. These are the types of opportunities that start to present themselves when everyone is chasing a market rally and IV becomes this stretched.

On the flip side, what happens the moment that spot stops rallying ? All of this stretched IV comes crashing down because it cannot be sustained. As an example, this is situation where you don't want to be long puts to bet that CVNA spot will decline after its recent rally since IV is too high and indeed puts would be quite expensive. If you think about it, this wouldn’t be the case during the classic market dynamic when IV spikes as spot declines (spot-down-vol-up). However, what happens if you own puts when IV is high and spot declines ? These puts are going to get crushed as IV gets crushed. The stock was ripping, IV was ripping as everyone was buying stocks and call options, and as soon as spot moves lower, IV will come down with it due to the unwinding of the long delta positions. You may have bought a put on CVNA and feeling great because spot is declining, but you're likely to be losing a tonne of money on the position depending on where the strike is because IV is likely coming down as well from its unsustainable levels. In this scenario, you would really need the spot price to decline dramatically in order to be profitable. Therefore, you want to be very careful in these situations when betting on downside.

To enter a short market position on CVNA in this scenario, the smart thing to do would be to sell calls, or even call spreads really, just in case spot gaps up again to avoid getting hurt on the position. Alternatively, if you're going to buy puts, you should focus on puts spreads because you want to offset some of that IV move, and you should shift more in-the-money where the options are less sensitive to IV. If you were to buy an ATM put on CVNA, you may have higher IV and may not make as much profit on the position as a result of spot-down-vol-down.

In conclusion, the options market indeed seems to be pushing markets higher and lower depending on flows and as well as dealer hedging (which is a whole other topic). Before entering an options position, it is wise to check how IV compares to historical vol, and if for the specific asset, it is currently in a spot-up-vol-up dynamic, and the inverse, as this can have significant negative effects on what you would expect to profit from the option position.