Quadruple Witching Expiration Miracles

Ivan Martchev  |

Last Friday was quadruple witching expiration day, which means options on futures, the futures contracts themselves, and options on stocks and indexes all expired on the same day. Some expired at the opening, while others expired at the close of trading, causing surreal moves in the futures market.

Derivatives are a fascinating field that is not appropriate for every investor, but the really intriguing thing about a derivative contract is that if one is making money on a derivatives contract, that means the opposite party is losing money, since it is a zero-sum game. If you buy a futures contract, that means somebody went short on the other side. If you buy a put or a call, a market maker most likely is short that contract on the other side of the trade. Market makers can hedge their exposure using various instruments and play the “bid-ask” spread arbitrage, but for the time being, I’ll focus only on the zero-sum aspect.

This chart marks the final minutes of trading in the S&P 500 June 2020 eMini futures contract (ESM20). Miraculously, a willing party (or parties) flooded the quote stream with bids and the ESM20 contract shot up to 3196 as it was about to expire at 9:30 am, just as trading opened on the NYSE for cash equities.

Below is the Friday trading of the S&P 500 September 2020 eMini futures contract. Note the high of the day near 9:30 am when the June contract expired at 3196. For the September contract, it is 3144.75 (futures trade in 0.25-point increments). That’s a difference of 51.25 points. After the June contract expired, it was straight down all day Friday for the September contract as the stock market opened up and closed down. In trading lingo, that is called an “outside down day” and can be a short-term reversal pattern. (There was a similar outside-down day on the German Dax on Thursday).

The reason those 51.25 points are absurd is because the normal difference between the two contracts is 11 points (it has to do with how carrying costs are calculated for cash settlement), so the normal spread between the June and September futures ballooned by an extra 40.25 points.

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An extra 40.25 points may not sound like a big deal to the untrained eye, but this translates to roughly 400 points on the Dow Jones Industrial Average, to use the most popular index for retail investors. That’s like manufacturing 400 Dow points out of thin air while the cash index never traded close to that level.

Such manipulation of the quote stream would make buyers of ESM20 futures near 3196 whole (as they were previously underwater), and sellers of those futures near that level would lose all the gains they thought they had a minute earlier.

I do not believe any of this price action is a coincidence. Somebody had a lot to gain by this miraculous last-minute spike in the ESM20 futures just before expiration – and the resources to make it happen.

The previously inversely correlated bedfellows – gold and the U.S. dollar – were positively correlated somewhere in the summer of 2018 and they have stuck together ever since. If one were to look for a good job description for hard money, like gold bullion, one could call gold “the anti-dollar,” so why are the anti-dollar and the dollar both rising? Both rebounded in the past two weeks after a small sell-off in May.

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I think the reason for this surreal positive correlation is the Federal Reserve. They are meddling so dramatically in many financial markets – to the tune of $7 trillion, which is the size of their balance sheet – that credit spreads, currencies, and maybe even stocks are at the mercy of the Federal Reserve.

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The fiscal and monetary response is three to four times more aggressive than anything we saw in the 2008-2009 Great Financial Crisis (GFC), and that much faster. The Federal Reserve is operating so far “out there” that the words “uncharted territory” don’t begin to describe the magnitude of the operation.

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In some respects, there was similar deficit spending in World War II, along with similar yield curve control and balance sheet operations, but it did result in high inflation in the late 1940s, which at one point approached 20% per year. One could say that the Fed at the time inflated away some WW2 debts.

Is the Fed trying to inflate away the Covid-19 and Financial Crisis debts?


Equities Contributor: Ivan Martchev

Source: Equities News

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