Market watchers in the US are concerned about the biggest January options expiration in a decade

(Bloomberg) — Market watchers on Wall Street attribute this week’s stock selling to the malign threat of a recession. However, derivatives traders are seeing a less ominous discount: the mass expiration of options on Friday — the biggest January event in a decade.

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Sitting on the sidelines when contracts are renewed has proven to be a winning strategy of late. That includes this week with the S&P 500 down for three straight sessions, the 12th time out of the past 14 months that the index has fallen so close to the OpEx.

Theories abound as to why this bearish event is persistent. One of them is just a coincidence, as the expiration happened to coincide with the release of bad macroeconomic news. Indeed, the sell-off worsened on Wednesday when data on retail sales and factory production rekindled growth concerns. However, other experts see the options market as having a significant impact. The thinking goes that losses in stocks may reflect unwinding of hedging by market makers, or traders using the liquidity window to sell stocks.

Either explanation could have been successful in halting a two-week rally due to optimism that inflation would slow and the economy would avoid a recession. Bulls burned by the latest downturn can take heart: Last year, stocks rose in the week after expiration on all but four occasions.

“This is actually a behavioral pattern that we’ve seen over and over again. If anything, it clears up one of the weakest weeks of the year,” said Leila Royer, senior equity derivatives sales representative at Citadel Securities. “And history will tell you you have a higher chance of going higher next week after Expiration.”

The OpEx event on Friday is going to be big. Nearly 180 million contacts are set to migrate, the highest January expiration rate in a decade, according to data compiled by Susquehanna International Group. Company data shows that thanks to a sudden rally in stocks at the start of 2023 around a weak inflation reading, open interest tends to be more bullish than last year, particularly among individual stocks and exchange-traded funds.

This sets Friday as another pivotal day, when holders of options associated with indices and individual stocks must either renew existing positions or initiate new positions. Because the process usually boosts trading volume, traders may choose to take advantage of the opportunity to exit stocks during last year’s bear market, contributing to a pattern of OpEx weeks that are bad for stocks, according to Chris Murphy, co-head of derivatives strategy at Susquehanna.

As the recession debate rages on, investors are increasingly turning to charts and technical forces for hints about market movements. Also cited among the catalysts for this week’s stock reversal were resistance at the S&P 500’s 200-day average and a drop below 20 in the Cboe’s Volatility Index, a measure of cost in options also known as the VIX.

Setting means that traders may choose to prepare for protection on the downside ahead of next month’s policy meeting by the Federal Open Market Committee, according to Brent Kochuba, founder of SpotGamma.

“So we’re having an opex with a heavy long position ending up in stocks, and implied volatility that’s oversold,” Kochuba said. “I think this puts a cap on stocks at the February 1 FOMC meeting as traders reposition themselves for long-term exposure.”

Already the demand for hedging is increasing. The S&P 500 divergence, a measure of the relative cost of selling versus buying, has been rising in recent weeks — reaching a three-month high. This is a departure from most of 2022, when the skew continued to fall in part because investors of all classes reduced their exposure to their stocks during the downturn.

The sudden spike in skew could be a sign that professional speculators are starting to add risky bets, a move that usually requires more hedging, according to Citadel’s Royer.

“Going into the year, there’s definitely been a little bit more of a reset in terms of people buying protection again,” she said. “There is a slight increase in total net exposure that may contribute to that. When insurance becomes cheaper, you are more willing to use the product.”

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