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$SPY Update, In-Depth Correction Analysis

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AMEX:SPY   SPDR S&P 500 ETF TRUST
This is going to be longer than usual because there are a lot things I found going on in our current market condition, as well as reasons to explain why the accelerated sell off occurred on Friday. I will discuss inflation , key ratios within the S&P 500 , quadruple witching day, options flow, Meme Stocks, and psychological factors. I hope this helps show direction and helps people better understand what we can expect for the week ahead.

Last Week’s Events:

First, I will start off with stating the macroeconomic and political factors that are well known, and that I also discussed in my $SPY post earlier this week. I anticipated a sell off on June 15th, assuming that the FOMC meeting would spook investors which we saw occur on Thursday, a massive sell off dropping the market 2 points, from 423, to 421 within seconds once the numbers were released. Clearly, the Fed was hawkish, and did not discuss anything along the lines of tapering, but did in fact mention rate hikes in 2023. Now, I know a lot of you will say 2023 is two years away, but let’s look at the bigger picture. Inflation is clearly something on everyone’s mind, and will greatly affect not only how far our USD gets us, but our ways of life and how we operate as a national economy.

Inflation:

How is inflation really affecting the economy? I mean, I'm sure you have noticed it by simply going out to the grocery store. Anyways, on Thursday, the Fed announced inflation jumped to nearly 5% in May compared to last year, which is the LARGEST 12 month spike we have seen since 2008. Interestingly enough, to add to that, the Fed also adjusted their forecast inflation to 3.4% for the year, compared to their previous projection of 2.4% they made in March. An increase of 1% within a 3 month period. Now is inflation always a bad thing? Absolutely not, inflation is generally a healthy part of economic expansion and growth, but are we truly seeing economic growth in the market especially? I would say no, which leads me to valuations.

Valuations:

Publicly listed companies are trading at all-time high for the most part. Is that a bad thing within itself? Not at all, but it is what’s behind it with all the other factors that make it nerve-wracking. By no means do I consider myself a traditional value or growth investor, primarily since my trades are based on technical analysis for current market conditions WITHIN the macroeconomic picture, but let’s look at some key ratios within the S&P 500 .

Price to Book Ratio:

CURRENT P/B Ratio - 4.49

2000's Dot Com Bubble P/B - 5. 05

We are currently near peak levels of P/B ratio that we have not seen since the dot com era.

Price to Earnings Ratio:

CURRENT P/E Ratio - 44.9

2000's Dot Com Bubble P/E - 46.9

Considering a majority of companies within the S&P 500 are trading at nearly 44 times earnings , investors are expecting these companies to perform and show parabolic growth to justify the price at which they are trading at. That’s fine and all, until the earnings aren't satisfying. Now, with investors putting their money into all these tech companies, they require a positive surprise in earnings every quarter, which has been slowing down significantly. Not only are earnings important, but returns as well in respect to inflation . As P/E Rises investors REQUIRE a higher rate of return on their investment to protect their purchasing power that allows them to keep up with inflation . I see an inverse relationship, as well as a shift in earnings from S&P 500 companies. A result of lacking positive earnings makes investors pull money from these companies as shareholders, in effect resulting in a sell off. Inflation projections continue to increase, and companies trading at 44 times earnings have expectations that are higher than the ceiling making it a very slippery slope.

Shiller PE Ratio:

CURRENT = 36.95

1930's Black Tuesday = 30.1

2000's Dot Com Era = 44.19

In all instances where we have the Shiller PE Ratio above 30, we have seen MAJOR market corrections and a complete change in economic trends and sentiment.

Bond Market and Yields

As the Fed continues to not yet have discussions of tapering, I feel the bond market is already pricing in rate hikes as well as tapering within the bond market. We see yields steadily rising as equity markets continued to roar, which generally have inverse relationships historically. The bond market is the largest market in the US financial system, and they generally tend to be right when yields begin to rise.

Meme Stocks

The rise of retail traders has in turn sparked a reddit based rally within certain securities in the equity market, where new investors who know little to nothing about call options and equity markets have the ability to participate in these financial instruments with nothing but a cell phone and social security number. These investors are expecting 100x returns within a week, adding to the problem of how a high P/B ratio means investors are expecting larger than average returns. As these beginner investors begin to see a shift in market conditions, many of them will either get completely wiped out, or take their money out of the market, causing even further downside pressure. We see that the massive rise in retail trading within the past year, courtesy of Robinhood and stimulus checks, has in a way made prices of US equities rise substantially with the market as a whole. This isn’t necessarily a problem until the market shifts. A market shift means all of these companies that are trading at 44 times earnings will have a rude awakening once institutions begin to take profits and retail withdraws money from equities.

We also have the short selling issue for institutions. These institutions who are extremely overleveraged, which was allowed during the beginning of the covid-19 pandemic, allowed firms to take on FURTHER leverage in order to stay afloat and recover from COVID-19 equity related losses. The short selling losses that they have incurred not only affect the firm itself, but other positions they hold as well. When a firm needs to meet a margin call because of the losses they are taking on all these meme stocks that have returned 1,000%+, they often have to liquidate other positions in their portfolio causing other equity prices to fall. We have already seen this in Archegos Capital, where the firm had to liquidate nearly its entire position in Viacom ( VIAC ), making the stock drop from nearly $100 to $30 within a few trading days.

*Note that short interest release date for S&P 500 equities is June 24th*

Quadruple Witching Day:

Many retail investors are not aware of what quadruple witching days are, and how they affect volatility within the markets in relationship to options and futures . Every year there are 4 days in which all types of options and futures contracts expire. Friday, June 18th 2021 was one of the Quadruple witching dates. Meaning expiration of contracts for equity index options, index futures , stock options in general, and single stock futures all on the same day. When all of these contracts are being either sold to another individual, or assigned, we have shares of the underlying index being massively affected in terms of volatility , where someone may exercise a SPY call, and immediately sell the shares or buy the shares required under the contract. Now, on quad witching days, generally how volatility works is dependent on the underlying movement in the security or index. What does this mean? It means that there is pressure from either side, bulls and bears, depending on the direction of the movement. For example, say Friday the S&P was strong in the morning, showing a clean reversal after Thursdays sell off, this would mean that there would be increased upside volatility because of options contracts being exercised and Market makers scrambling to get them shares at the best price they can, meaning a bullish melt-up. But it works the other way around too which is why the selling on Friday was so accelerated, especially in the last hour of trading where a significant amount of contracts are assigned and exercised.


Other than QUAD Witching referring to options expiration, we also have other variables in the mix that affect the market that generally come soon after. The following are such

1. S&P Rebalance for 400, 500, 600

2. Short Interest Data Release


Previous Quad Witching Days with SPY 1D Performance:

March 20 2020: -4.87%

June 19 2020: -1.01%

September 18 2020: -1.55%

December 18 2020: -0.82%

March 19 2021: -0.51%

June 18 2021: -1.67%

September 17 2021: NA

September 2021: NA

Gamma ( GEX ):

This is where Gamma exposure comes into play. Looking at gamma exposure in terms of strike for SPY , June 18th key pivot levels for contracts expiring was in between the 422 and 421 strikes. Meaning SPY under 421 would see selling pressure that exponentially moves higher in GEX as the index declined, and we saw massive downside gamma exposure in SPY under 421 on June 18th, which is exactly what occurred. Then under 420, heavy GEX sell side pressure with a value of -500. And it doesn’t stop there, we closed after hours at 413.60 for SPY , meaning the sell side pressure should and will most likely continue into next week. Gamma exposure according to strikes was the following. How Gamma exposure works on the day of expiration can be defined as such.

For positive Gamma ( GEX ), MM's will move in the opposite to the underlying stock move, resulting in REDUCED volatility

For NEGATIVE Gamma ( GEX ), MM's will move in the same direction as the UNDERLYING move thus creating increased volatility .

425 = +658M

422 = +154M

421 = -156M

420 = -500M < SIGNIFICANT SELL PRESSURE

419 = -169M

417 = -214M

415 = -405M < SIGNIFICANT SELL PRESSURE

410 = -407M < SIGNIFICANT SELL PRESSURE

400 = -385M < SIGNIFICANT SELL PRESSURE

TOTAL GEX EXPOSURE AS OF CLOSE 6/18= -2956.17M

TOTAL GEX EXPOSURE AS OF CLOSE 6/17= 1663.23M

Okay so what does all of this mean? Refer to the chart to see how gamma exposure affected the sell off on Friday, and how we can assume it will affect the market on Monday. As you can see from the table above, at those key price points in spy , once the respective price point was broken, a large sell off occurred in RELATION to the GEX value. SPY under 420, sell off with bounces in between 417 – 419. SPY under 417, massive sell off again towards the 415 level, we then broke the 415 level, triggering another sell off at the close to 414.92. After hours, dropping AGAIN another 1.32 points to 413.60. Gamma exposure is ALL now to the downside because of negative GEX and the move in the underlying index being to the down side. This creates massive sell off's that does not only occur on options expiration day, but for proceeding days or even weeks after because of how options are settled and because they truly are not expired until the following business day AFTER expiration at 5:30 PM.

Options Expiration & SPY Close on June 18th:

SPY closing under 415 at 414.92 is a bad sign, does 8 cents really matter in the grand scheme of things? Yes, it actually does. To be ITM on expiration, the underlying security must be ATLEAST 1 cent in the money at expiration. Meaning a SPY close of 415. 01 would mean maybe we found a floor for the time being. Since we closed BELOW that strike, we now have 407M in sell pressure to the downside, and we saw this after hours with the 1.32 point drop which I believe will send us to near 410 on Monday. To assume that contracts for expiration on June 18th have been fully completely exercised or assigned is very unlikely, being that options expiration is technically Monday at 5:30. As a result, the sell side pressure should continue into Monday and the rest of the week as investors panic and GEX increases volatility .

Pervasive Effects Of GEX & Options Market

Another point I would like to raise if how the options market influences the underlying index itself, and how investors gauge alpha and volatility in accordance to the current price of an asset. As a risk manager, you consider factors of alpha to determine the risk in ones portfolio and hedge accordingly or wait until “the price is right”. There is also the psychological aspect of investors that the options market has the effect of “spooking” the market. Let’s use Friday as an example. So obviously we have quad witching day as a day where live options flow and analyzing institutional options orders might not make a lot of sense because of the hundreds and thousands of options contracts being assigned, exercised, and traded throughout the day as investors price in their bets. BUT, if we look at the overall heatmap of options and how it may scare investors, we can see how it affects the underlying index. If on Friday at the close, the heatmap was many ITM /OTM call option premiums that outweighed put options, the market sentiment for the following week may actually flip to a bullish reversal, instead, we see the following below.

Options Heatmap:

We can also look at the options heatmap as of Friday, representing the top traded contracts in terms of premiums spent and volume for SPY . This to me, also confirms that the selling is not over.

8/20/2021 445 PUT - 11.58$MIL
8/20/2021 396 PUT - 10.25$MIL
1/21/2022 373 PUT - 4.8$MIL
8/20/2021 410 PUT - 4$MIL
and many many other put options

Market Makers, Delta, & Pinning

Another interesting aspect of the options market is how market makers have a goal of remaining in net delta neutral positions for contracts traded in order to hedge and minimize risk. This leads us to pinning, which is a phenomenon that occurs on options expiration in accordance to what strike the majority of the contracts are at. Pinning arises from hedging pressures. The best way to describe this is to look at the strike prices in their majority, in order to understand the supply and demand behind it. Pinning is when the options market “pins” an underlying index to a specific strike price because of the option expiration, meaning the price will gravitate towards the strike contract with the most volume . When the price of an underlying index is ABOVE the “pinning” price, it creates increased supply above the strike, meaning less demand. Vice versa occurs when the underlying index is BELOW the strike price, which creates an increase in demand. So what happens when the underlying index rises and market makers become more delta positive when their goal is to remain delta neutral? They sell stock, because stock has the highest delta, resulting in large sell orders in order for MM’s to become delta neutral.

Gamma Magnet & Open Interest

The last point I will make is in regards to how strikes with the highest open interest act also influence the “pinning” price, and how this in turn acts as a gamma magnet towards a specific strike. When a volatile move in either direction is occurring, the options market in respect to strikes with the highest open interest act as a magnet that magnifies the underlying move. So how does the gamma magnet work? In action, once an underlying index is making a move towards a specific strike in relation to the strike with the highest open interest, MM’s who are hedging contracts have to make decisions in order to remain as delta neutral as possible. Meaning as prices RISE, MM’s are forced to buy shares, and as prices fall, they are forced to sell shares for MM’s who are short calls or short puts.

Current Data & Conclusion

On June 17th, the day prior to witching day, I was doing some research on the top contracts expiring the next day, dominant strikes and expirations for contracts expiring on June 18th were call options for strikes between the range of 390-400. These being the MOST contracts being traded and expiring on June 18th, (but don’t actually expire until Monday). This being one of the strike prices that the underlying index is gravitating towards because of the respective strike price, which we have not even reached yet.

1. Gamma

TOTAL GEX EXPOSURE AS OF CLOSE 6/17= 1663.23M

SPY Performance 6/18 = -1.35% (BUT -1.67% as of the close post market)

TOTAL GEX EXPOSURE AS OF CLOSE 6/18= -2956.17M

SPY Performance 6/21 = N/A

According to the Gamma exposure, negative gamma will have a detrimental effect to the market for the following week as MM’s are forced to sell, and price gravitates towards highest volume of contracts for specific strikes, being in between 390-400 on 6/17, and as of the close on Friday, dominant strikes at 392 & 410 on 6/18.

Yet again, we see highest open interest near the 410, 400, 392, 375, 345 Levels, in which prices will gravitate towards rapidly because of downside movement that will be amplified due to gamma exposure and open interest in relation to the strikes, meaning accelerated downside momentum.



In conclusion, I see inflation , options market data in respect to gamma based movements by MM’s, and psychological sentiment shifts ultimately causing a market correction. As well as meme stock hype where investors are expecting 100x returns in a day through call options and stock purchases causing a mass panic within retail investors when they see the market taking a turn, sparking a panic sell off within equity markets. Institution’s will end up also liquidating positions in order to meet margin calls and leverage requirements. The political and macroeconomic factors, as well as everything going on the inside of the market, will cause a drastic shift in market conditions and increased volatility .