Options Turn Upheavals Into a Mid-Month Sure Thing for S&P 500

(Bloomberg) — What can you say about a stock market grown so predictable that even its bouts of chaos now occur at regular intervals? A lot, when options whizzes get involved.

A mid-month storm of volatility has emerged as a semi-predictable occurrence recently, a presence once recognizable only to specialists but now drawing the attention of an ever-larger crowd on Wall Street.

You saw it in July, when the S&P 500 lurched 2.3% lower over two sessions through the 19th. In June, the index had its largest drop on the 18th. April saw the benchmark swoon for two days from the 19th to the 20th. In February, it dropped 2.5% in the week starting the 22nd. The pattern was reprised this month when equities had their biggest slide of August on the 17th and 18th.

What all these things have in common is they happened around the third Friday of the month, when most stock options expire. While anything that explains the market’s mysterious moves is bound to get attention, the turbulence around this event — known colloquially as OpEx — has become a source of fascination because it upends the traditional relationship between options and their underlying assets. What it suggests is that the stock market has effectively become a derivative of its own derivative — the tail wagging the dog.

“The monthly option expiration is what wins people over to the realization that options have a huge impact on the underlying,” said Matt Zambito, founder of analytics service SqueezeMetrics and an early publicizer of the phenomenon.

While specialists say this dynamic has existed for decades, it has intensified over the past year as options activity surges to unprecedented levels. Between day traders buying speculative calls, yield-seekers selling them, and institutional hedgers loading up on protective puts, options volume and open interest are soaring — leaving market-makers struggling to absorb all the flow.

“We’ve never seen this many people trading this many options, and that’s a lot for the system to digest,” said Steve Sosnick, chief strategist at Interactive Brokers LLC and a former market maker.

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Dealer’s Choice

Like anything in markets, it’s unwise to assume any explanation is the whole story — but quite a few come back to options dealers when deciphering the mid-month storms. Why dealers? Loath to take on directional exposures, they’re the most active hedgers in the market. And the thinking goes that their buying and selling has grown large enough to move stocks almost like clockwork.

Here’s how it works. When an investor buys or sells an option, the other side of that trade is taken up by a market maker. These dealers typically balance their books through buying and selling the underlying stock or index futures.

It’s this buying and selling that is said to create recognizable patterns around OpEx. In the run-up to expiration, dealers are thought to neutralize volatility by selling into rallies and buying on declines — and there…