In recent weeks, volatility in the stock market has been elevated as investors and traders hedge against potential risks associated with the Federal Reserve and an economic slowdown. The initial concerns began with worries over inflation and growth but have since shifted to fears that the Fed's monetary policy could lead to an economic recession or "hard landing."
Options expiration has been a key source of volatility in recent months, and this week is no different. It's estimated that more than 30% of the SPY (a popular stock market ETF) will see their options expire this Friday, May 20. That could lead to more extreme swings in the market as investors attempt to adjust their positions.
In addition, the Fed minutes from the most recent meeting are due to be released on Wednesday, May 25. These minutes could provide further insight into the Fed's thinking on the economy and interest rates and, if viewed negatively, could spark additional selling.
The unwinding of hedges supported the market.
The unwinding of hedges (i.e., bets against the market) helped support the market in April. When the options expired, there were more "buy" orders than "sell" orders, which helped keep the market prices up.
The gamma levels, which show the amount of the underlying asset that must be bought or sold to hedge an option position, fall as options expiry approaches. That reduces the requirement to purchase or sell the underlying asset to hedge an option position.
However, when the delta flows (which indicate the amount of the underlying asset being bought or sold to hedge an option position) begin to turn negative.
That indicates that traders are beginning to buy put options (options that give the holder the right to sell the underlying asset at a specified price) and sell calls (options that provide the holder the right to buy the underlying asset at a specified price).
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That is usually to protect/hedge their position against a possible decline in the underlying asset's price.
The release of the Federal Reserve's minutes may have a significant influence on the stock market since they reveal the Federal Reserve's monetary policy thinking.
Suppose the minutes are seen as hawkish, indicating that the Federal Reserve moves toward tighter monetary policy. It might cause a sell-off in stocks as traders arrange new hedges to protect against future drops.
Suppose the minutes are dovish, indicating that the Fed is moving toward a looser monetary policy. It might lead to a relief bounce in the stock market as traders reduce their exposure to hedging instruments.
The Fed's most recent meeting minutes were revealed today, and since the beginning of the year, the markets have reacted unfavorably. That has resulted in a decline in stock prices and a rise in the VIX (Volatility Index), a measure of market volatility. The minutes showed that the Fed is contemplating a rate hike sooner than anticipated, causing investors to worry that the Fed may tighten monetary policy too rapidly.
As investors concentrate on the next Fed meeting in June and the estimates that will be made at that time, there is a substantial downside risk in the market. That might result in increased selling pressure in the coming weeks, resulting in lower stock prices.