Conspiracy theories abound, and some investors lose big on unusual S&P pricing. If the cause was fear of rising rates, the problem may return.
The hot topic Tuesday on Wall Street was far from ordinary, and had little to do with the usual worries about economic growth, Russia's invasion of Ukraine, or China's wobbly financial market.
Traders were scratching their heads, and even spinning conspiracy theories, about the unusual aftermath of Friday's expiration of futures and options.
On Monday, just as the market opened, the price of many stocks surged so much that the settlement of derivatives tied to the Standard & Poor's 500 index occurred at a price some 10 points higher than Friday's closing price.
This stunned many traders because settlement prices usually align with closing prices from the night before. These traders lost money. It's hard to say how much everyone lost, but it was enough that Chicago derivatives exchanges were peppered with questions from riled traders demanding to know what happened.
Though there has been some speculation that the unusual trading was related to algorithmic traders manipulating the stock, options and futures markets, a simpler explanation is more probable. Many big investors regularly engage in "funding trades" that are designed to arbitrage money by trading similar, yet different markets. While this type of stuff may seem exotic to ordinary stock and bond investors, the markets are stitched together by relationships, and slight differences, between stocks and derivatives. Sometimes, very big trades can roil the markets, and that is what probably happened Monday.
A big program trader is thought to have been long S&P 500 futures and short each of the stocks in the index. Because the fund was short stocks, the fund was paid by its brokerage firm or clearing firm what's known as a short stock rebate. The rebates tend to be higher than the amount of interest that can be earned in a money-market account. This type of funding transaction can be very lucrative when large sums of money are involved. The risk is relatively muted because buying a futures contract covers the risk that a basket of short stocks will increase in price. How? The futures contract value will increase, and that offsets the impact of short stocks rallying higher. Futures prices also reflect dividend expectations for stocks.
The natural question now is why did this program trader decide to exit a profitable trade with little risk? The answer: rising interest rates. Many investors are now uncertain when the Federal Reserve may finally raise interest rates. They are confused by the bank's statements after the recent rate-setting committee meeting. Rather than waiting to see if the bank raises rates six months after tapering ends, as some now think, or later, as almost everyone previously thought, this major program trader decided to exit his large position in stocks and S&P 500 derivatives. He sold long derivatives, and bought short stocks. The volume was so much larger than what ordinarily trades at the open that it managed to push prices sharply higher in some stocks.
Steve Sosnick, the risk manager for Timber Hill, one of the world's largest derivatives trading firms, explained in a communiqué for customers of his firm's parent company, Interactive Brokers (ticker: IBKR), what happened Monday morning.
" Apple (AAPL) opened at $533.68 at 9:30:00, which was its high for the day. Goldman Sachs (GS) opened at $170.00, which was also its high for the day. As GS was opening, AAPL had declined to $532.07. Within a minute, both AAPL and GS were nearly 50 cents lower. This is a tiny sample of an opening that was characterized by most index components opening at or near their highs of the day. Because the early opening stocks were already declining as laggards opened later, the index computation using 500 official opening prices was able to greatly outstrip the observed high of the day," Sosnick wrote in a post.
For those keeping score at home: Sosnick is using opening prices from the stocks' primary exchanges; consolidated prices are slightly different.
All of this bobbing up and down in the stock market rippled through the derivatives market. Remember, the final values of expiring contracts are based on the value of the underlying stocks at the open. Because stocks open at slightly different times during the first few minutes of trading, the index settlement price can occur outside the observed range of the S&P index. "That was the case on Friday, as the settlement price of the index was 1,893.30. The highest level of the index during the trading day was only 1,883.97. That meant that holders of the 1,890 strike call options received an unexpected windfall as their seemingly worthless options suddenly expired in the money. The opposite happened to put holders," Sosnick explained.
Bottom line: Investors must now treat options and futures expirations as potentially volatile events with unexpected outcomes. It is hard to say if the recent expiration was an isolated event or the start of a trend as investors prepare for higher interest rates. Until the answer becomes clearer, treat options and futures expirations as events to be anticipated, and feared.