By: Dividend Sensei
Despite the very rapid correction, tied for the fastest in Nasdaq history, a remarkable three days, stocks are still enjoying what Ben Carlson calls a “face-ripping rally”.
3 Day 10% Plunge Tied For The Fastest Correction In Nasdaq History
(Source: Market Watch)
However, there might be a perfect storm coming for stocks that could turn this pullback into a full-blown correction, or possibly even an unprecedented bear market.
Here are the four potential risk catalysts that investors need to know to potentially prepare themselves for a return to the kind of market volatility that traumatized so many earlier this year.
Friday, September 18th Is A Potentially Very Important Day For The Stock Market
Friday, September 18th is the quarterly options expiration, which is called the “quadruple witching” because it can result in extreme volatility when options contracts expire.
Why should stock investors care? Because according to Refinitiv economist Roger Hurst the number of options sold in recent months was 5X the previous record set back in early 2000.
Options are a way to leverage short-term stock market moves, in either direction.
- call options allow you to make leveraged bets that stocks will go up
- put options allow for leveraged bets that stocks will go down
Options are apparently a favorite of the Robinhood crowd, who isn’t satisfied merely speculating on short-term stock moves but wants to amplify short-term gains (and losses) the way only options allow.
When options are sold, either calls or puts, the market maker (usually your broker) doesn’t just keep those naked, which exposes them to potentially significant losses.
Rather they hedge the positions by buying or selling the underlying stock (or index funds) to protect themselves.
Normally the number of shares required is a fraction of the 100 shares each option represents, say 10 shares.
However, if the stock price moves close to the strike price of the option, the number of shares the market maker must hedge rises (known as “delta”). This can sometimes result in the market maker having to sell or buy a full 100 shares of the underlying stock for each option sold.
The closer the option gets to the expiration date the more shares a market maker must hedge via either buying or selling the underlying security.
The rate of new hedging required via selling or buying more shares as the time to expiration falls is called “gamma”.
On the 3rd Friday of each quarter the quarterly expiration date, known as the quadruple witching, can result in extremely high volatility if the stock market has a specific trend, such as a correction, occurring at the time.
Mr. Hurst is careful to point out that quarterly option expirations don’t always result in wild swings in the stock market, such as 6% declines seen on June 11th, but they represent a potential risk catalyst that can turn a mere pullback into an outright correction.
Which brings us to the second potential catalyst that might make for a wild few weeks for stocks, possibly even triggering a second bear market in the same year, something that has literally never happened in the history of the US stock market.