Staying Liquid

Vol #50 - August 20th, 2021

As August expiration week comes to a close, we have seen a ping-ponging of broad market indices as the few traders stuck to their desks attempt to stay ahead of the game.

Not only are there big positions to unwind, but there are fewer participants to do so. The ability to place a trade is entirely dependent on having someone who is willing to take the other side. What if that other side is in the Hamptons?

Liquidity is one of the most powerful forces in markets and investing. Traders care about liquidity because it represents their ability to get in - and more importantly out - of a trade. Exchange operators obsess about building and maintaining liquidity to demonstrate their value as a venue. 

As powerful as it is, liquidity can also be extremely ephemeral. For anyone who has watched live market data, you can see the buyers and sellers slowly nudge price one direction and the other. As buying interest builds, prices will slowly rise; and as more sellers come to meet that price it will fade. 

Then all of the sudden there are air pockets. Prices which have bounced around within tight ranges for minutes and hours quickly break out. 

Markets are organic and full of feedback loops. In addition to the swirl of human emotion stirred by financial Twitter and CNBC, algorithms are sending millions of quotes per minute attempting to anticipate and get ahead of price movements. This can create some very strange effects.

Options and futures expiration adds yet another dimension to this game. It’s no surprise that with this week being a monthly expiration in summertime, that markets have been slightly choppier than usual. Sure we know that volatility clusters, but there are also structural reasons why this week might see bigger than average swings. 

There is a very real effect on the markets when there are fewer participants. When tape readers analyze the volume and price action, they give less credence to moves that happen on lower volume. Price moves on lower volume are less likely to follow through. 

Not only are there fewer participants, but there’s more inventory to be moved. As expiration approaches, derivatives positions see their most significant changes. In order to keep the desired exposure, managers must roll or adjust these positions. 

Theta decay is not dissimilar to the way Hemmingway described going bankrupt - “gradually, then suddenly.”  Assuming things stay relatively constant, the differences between a 30 day option and a 29 day option aren’t all that much. But the difference between 1 day left and 0 days left is a big deal. 

The potential energy of an option melts away as the final hours tick by. This decaying of value means that the overall position is changing rapidly too, and requires an unwinding of hedges and rebalancing of risk. 

Monthly expirations tend to be larger concentration of positions because they have been listed for the longest period of time. This liquidity is self-reinforcing, as investors are more likely to choose the actively traded contracts for a better quality execution and chance of getting a good fill. 

With only a few hours left on the August contracts, expect to see some bounce; it’s how the markets do their job.