The Fed Just Broke Something

٤ يناير ٢٠٢٣

The chart above shows the CBOE Equity Put Call Ratio (CPCS).

Last week the put-call ratio broke its all-time record high, surpassing the levels seen during the Global Financial Crisis and the March 2020 market crash by almost twice as much. In this post, I will explain my thoughts about what's going on. I welcome others to also give their thoughts in the comments below.

Let's begin with the basics of the put-call ratio. The put-call ratio is simply a measure of the relative amount of trading in put options versus call options. Typically the put-call ratio rises during periods of extreme fear in the market, when volatility is also high. Historically, the put-call ratio has been used as a contrarian indicator, meaning that when it is very high it signals that too many market participants are bearish and when it is very low it signals that too many market participants are bullish. Typically anything above 1 is considered too bearish. A put-call ratio above 1 has historically marked significant stock market bottoms.

However, something very strange has been happening recently. The put-call ratio has been exploding to such extreme levels that some people are now saying the indicator is broken. Last week, the put-call ratio reached an insanely high level (2.4). Yet, on the day this record spike happened, the VIX was in the low 20s, which is only modestly elevated, (see the chart below).


As the chart above shows, a VIX in the low 20s is only slightly above normal.

The put-call ratio was so extreme last week that one would have expected the VIX to be off-the-charts. In the chart below, I've calculated the general area (marked by a flag) of where we would have expected the VIX to be if the put-call ratio accurately corresponded to such an extreme put-call ratio.



Some market analysts and many people on social media are attributing the unprecedented spike to 0DTE, or Zero Days To Expiration, options trading. Zero Days To Expiration refers to options that are traded on the same day (or within 24 hours) that they expire. This speculative form of trading has proliferated over the past year. Those who cite 0DTE as the reason for a malfunctioning put-call ratio argue that its utility as a contrarian indicator has become confounded at best, or noisy and meaningless at worst.

The below chart shows the proliferation of Zero Days To Expiration options trading.



When compared alongside the put-call ratio, we can visually garner a potentially high correlation.



Some market analysts have stated that the proliferation of 0DTE options trading has become so disruptive that not only has it broken the role that the put-call ratio plays as a contrarian indicator, but it has broken the essential role that the VIX plays in measuring volatility. The VIX, which is calculated based on only S&P 500 options expiring 23 to 37 days into the future, may not be properly capturing the true panicked nature of market participants who are mostly trading options with much less time until expiration.

Yet, questions remain, even when considering the rising prevalence of 0DTE options trading. Specifically, why is 0DTE causing puts trading, in particular, to increase so dramatically?

The answer is likely that 0DTE option trading is not the only cause of the exploding put-call ratio. Some informed market participants have argued that the Fed's extreme monetary tightening is largely to blame, though their reasoning is not as obvious as it may seem. Although it's likely true that the Fed's tightening is likely driving up fear and causing market participants to load up on puts. The more informed explanation involves an arbitrage strategy that seeks to take advantage of those who are loading up on puts.

An academic paper entitled, Put Option Exercise and Short Stock Interest Arbitrage, explains this strategy. The strategy takes advantage of those holding deep in-the-money puts with no time value remaining and which ought to be exercised such that the cash can earn interest.


Above is a screenshot of the academic paper, which I cannot distribute because of copyright restrictions. I can only show the abstract which is publicly available.

For educational purposes, I will cite a small excerpt from the article to explain exactly how the strategy works:

The game involves capturing short open interest. The game, dubbed “short stock interest arbitrage,” involves simultaneously buying and selling a large (relative to existing open interest), but equal, number of deep ITM puts and then immediately exercising the long puts. Since exercises are randomly assigned to open short positions, the arbitragers systematically capture the dominant share of the total short open interest and thereby earn the dominant share of the forfeit interest.

Now that the Federal Reserve has dramatically hiked interest rates, this strategy is much more lucrative than in the past since the interest that can be earned by arbitragers is much higher. Furthermore, the stock market's decline in 2022 caused more puts to become in the money thereby expanding the volume of puts traded by arbitrageurs. Since this strategy is non-directional, meaning the strategy involves simultaneously buying and selling an equal number of puts, its net effect is theoretically zero. Thus, this strategy's proliferation may be causing the put-call ratio to malfunction.

Despite these reasons, other market participants have speculated that the extremely high put-call ratio is due to large institutions and other informed market players loading up on large hedges because they believe a major market crash is coming. While this is largely speculative, there is some evidence that informed institutions are becoming increasingly concerned about a liquidity crisis due to the Federal Reserve's tightening. Last month, the Bank for International Settlements (BIS) recently issued an unusual warning about the potential for a liquidity crisis in the global FX swaps and forwards market.

Link to the BIS article: https://www.bis.org/publ/qtrpdf/r_qt2212h.htm

The BIS, which is often thought of as the central bank for central banks, explained that dollar payment obligations in the FX swaps and forwards market are generally not recorded on balance sheets and that the risks associated with these debts could be understated by tens of trillions of dollars. In effect, the Federal Reserve's rapid rate hikes have caused the U.S. dollar to rapidly become more valuable relative to other currencies, creating risks in the FX swaps and forwards market that were not fully anticipated.

In some regards, the actual causes of the breakdown of the put-call ratio are not as relevant as the mere fact that it has broken down. According to Exter's Pyramid (shown below), during periods of extreme instability of asset classes lower down on the inverted pyramid, everything higher up becomes some degree more unstable. The meteoric rise in Treasury yields has made everything above shakier, especially derivatives. Rapidly rising Treasury yields are destabilizing the highly-leveraged derivatives market in unanticipated ways.

 

Now that U.S. Treasurys suddenly yield much more, this means that capital will tend to flow lower down the pyramid into them. Leaving riskier assets higher up vulnerable to collapse.

Despite all of this, some market participants continue to believe that the put-call ratio is still a reliable contrarian indicator. These market participants argue that whenever fear is high, people always say "this time is different" when in fact it is not. They believe that not only is the put-call ratio indicator still working but it is indicating a high chance for a major short squeeze.

Only time will tell what will become of the current situation. Yet, one thing is for certain. Despite the highest put-call ratio on record last week, the rules of good trading and good investing remain the same. No matter the fear, volatility or crisis that may transpire, if one adheres to these principles, one will be successful.





Sources
[1] Barraclough, Kathryn and Whaley, Robert E., Put Option Exercise and Short Stock Interest Arbitrage (May 17, 2013). Journal of Investment Management (JOIM), First Quarter 2013, Available at SSRN: ssrn.com/abstract=2266663

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ملاحظة

The Equity Put/Call Ratio has been so volatile lately that its rate of change (ROC) registered a record decline immediately after registering a record increase.



When liquidity stress becomes extreme, derivative markets can often begin to malfunction in unanticipated ways.