Brett Freeze, one of my financial market mentors, has several rules that summarize his core trading beliefs.  His first rule is “never, ever be short gamma.”

More simply, the rule could read “never sell uncovered options.”  Anyone who has received a margin call on their uncovered option positions understands intimately why this is a prudent rule.  Options are a leveraged bet on an underlying security, so when price moves against the option, the financial losses and margin calls can happen quickly and are virtually unlimited.

For Optionsellers.com, a hedge fund that had to shut down in late 2018, selling uncovered options was the explicit strategy.  It is in their name, after all.

In hindsight, we might conclude that naked selling of options is better handled by machine-driven market makers (banks/brokers).  The market makers instantaneously can hedge their exposure with other options positions and long/short positions in the underlying security.  The market makers can not only instantaneously lay off risk, they can also respond to volatility more quickly, and adjust positions accordingly. The market makers limit their risk in a way that most individuals and hedge funds cannot.

I am not attempting to arm-chair quarterback the demise of Optionsellers.com, nor do I want to “kick anyone while they are down.”  We all make mistakes, and none of us enjoy failure, especially in the public square.  I sincerely wish the best for the principals and investors in Optionsellers.com, and hope all matters are resolved with fairness.  I had an account with MF Global when it went under, so I understand the feeling of bewilderment many investors must feel.

It has been said that wisdom is learning from the mistakes of others, so our intention here is to understand what happened, and learn from it.  As a starting point, retail traders might consider Brett Freeze’s rule #1 – “never ever be short gamma.”

Gamma Squeeze

Options traders closely watch the value of delta and gamma. Delta is a measure of the volatility of an option price, and gamma is a measure of the volatility of delta.  In my daily report, I publish the value at which delta and gamma will be neutral for a given security.  We define “gamma neutral” as the price level at which the total options market gamma would equal zero.

Over the past several months, there have been two high-profile occasions where neutral gamma spiked far from the value of the underlying security.  The first time coincided with the collapse of optionsellers.com in mid-November 2018, and the second time was the stock market declines before Christmas 2018.  We intend to cover the S&P gamma in another article.

The simple explanation for the collapse of Optionsellers.com was that the fund was net short natural gas options, and the price in the natural gas (NG) market spiked.  In options parlance, the fund was short gamma and the market moved violently in the opposite direction.  Optionsellers.com was not the only fund that was short the options market at that time, of course.  The natural gas options market was as a whole sitting on the wrong side of the boat the time that the price surge occurred, and we can see that in the data that I publish each morning.

With the options market tilted net short, the spike in November natural gas prices turned into an old-fashioned short squeeze.  Optionsellers.com and the many net short NG traders had to cover their positions.  Short covering plus momentum long trading equals “squeeze” and in this case it became an eye popping upward move.

The chart above shows the underlying natural gas futures price in green, the point of neutral delta in red and the point of neutral gamma in blue.  For reasons that can be explained by order flow, the red and green line will tend to converge on or before the options expiration date (black box.) The blue and the green line will also tend to converge, but if the blue line moves way out of range in the other direction, then we can see a short or a long squeeze of one kind or another, such as in mid- and late-November.

Final Thoughts

These are advanced topics, and I have learned considerably from interacting with many of my readers and subscribers.  If you would like to join in this discussion, please drop me an e-mail at admin@viking-analytics.com, and/or visit my page on Price Magnets at  www.viking-analytics.com to learn more.

I have no specific knowledge of anything related to the Optionsellers.com recent demise other than what has been openly published on the internet.

All Quiet on the Western Front is a 1929 novel which describes German soldiers’ extreme physical and mental stress during World War I, and subsequent detachment from civilian life felt by many soldiers upon returning home.  This novel was eventually made into a major motion picture.

The phrase “all quiet on the Western Front” has become a colloquial expression meaning stagnation, or lack of meaningful change, in any context.

Many financial markets ended 2018 with considerable volatility.  The stock market, as measured by the S&P 500 index, fell from its peak in early October to a December 26th low by over 21%. The WTI crude oil market fell from an October peak over $77/bbl to a December 24th low near $42/bbl, a 45% decline.  The natural gas market spiked considerably in November, only to fade significantly in December.  At least one hedge fund, optionsellers.com, was forced to shutter from these extreme moves in price.

Since the beginning of 2019, stock market volatility has been subdued (at least in comparison to the fourth quarter).  The average trading ranges for the S&P 500 index has diminished considerably, at least for now.  In hindsight, we might view some of the large market moves in late 2018 to have been end-of-year positioning and/or profit taking, with January as a mean-reversion month.

January has largely been “quiet on the Midwestern front.”  “Midwestern” is used here because the most influential options markets are conducted on Chicago exchanges –CME Group and the CBOE.  Many readers may be surprised to learn that some options markets actually have more value at risk than the futures and cash markets themselves.  In some cases and on certain days, the options market can become the tail that wags the dog of the underlying markets.

Op-ex Price Magnets

Over the last several years, we have developed a trading indicator that relies on mean-reverting behavior in about a dozen markets. The Op-ex Price Magnet is our proprietary tool which shows where options markets have priced in an “ideal” option expiration price, the value at which total market delta is neutral.  We can demonstrate mean-reversion behavior towards market delta neutral in many different markets and exemplified by the graph below.

This tool can be considered to be an “options sentiment index,” and therefore it is not necessary to trade futures or even options to use the tool.  As a sentiment indicator, the Price Magnet tool shows where the market makers are expected to maximize profits for about a dozen different markets.  Here is a sample graph for the S&P 500 options traded on CBOE.

There are two important dynamics to consider in the graph above.  First, the price (the green line) will often mean-revert back to the point of delta neutral (the red line).  This dynamic can be attributed to order flow and market maker positioning into options expiration.

The other dynamic – seen in late December – shows where gamma can spike, resulting in a “gamma covering” event.  We believe that the sharp declines in and around Christmas can be attributed in part to forced selling by the market makers to bring their gamma back in line by covering their options losses.  A similar dynamic happened in the natural gas market in and around the time that optionsellers.com was forced to liquidate.

This is a relatively complicated topic, so we encourage readers to visit our website or send us an e-mail if you have specific questions on this methodology.  As a practical consideration, our published articles on trading the S&P 500 index during 2018 resulted in successful trades more than 80% of the time (verifiable through Seeking Alpha).

Friday, January 18^th was the first monthly expiration for S&P 500 (SPX) options, stocks and ETFs.  This week there is a monthly expiration for grains and US Treasury futures.  Next week, there is a monthly expiration for both gold and natural gas. We don’t currently see high probability mean-reversion trades in any of these key markets, but that could change quickly. 

The following table is an example of the summary data that is included in our daily reports.

Thank you for reading our work and we look forward to providing more guidance on markets that have strong Price Magnets into option expiration.