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IPFS News Link • Economic Theory

It's Feeling Like "Last Days Of Rome": Market Heading For Giant Gamma-Squeeze Blow-Off

•, By Simon White

FOMO is once again in evidence as both the S&P and the Nasdaq make new highs. If you fear you're already missing out, what better strategy than to use the gearing of options to make up for lost ground? This could drive a potent self-fulfilling rally that contains the seeds of its own demise (ZH: see ""Everyone Is In The Same Trades And All-In": Goldman Tells Clients To Get Out Of "Parabolic" Tech Stocks").

Options are the financial crystallization of greed and fear. Buy call options when greedy; buy put options when fearful. And if you're only somewhat greedy and not too fearful, you can sell calls or puts. Today, greed is in the ascendant and fear is in abeyance. That's a recipe for a blow-off top.

How can this happen? Over the past month, S&P call prices have risen more than put prices. The red line in the chart below is of S&P option prices by strike a month ago, while the white line is their price today.

The white line has risen more than the red line on the right-hand side of the chart, that is at higher strikes, versus at lower strikes. This shows it is likely investors are buying more calls than puts, i.e. they are increasingly taking leveraged long positions on the market with unlimited upside. Falling put/call ratios, both in price and volume terms, corroborate this. The effect is even more pronounced in tech and the Magnificent 7.

This sort of action has the potential to lead to a rapid rise in stock prices that finally exhausts itself, culminating in an abrupt selloff. The reason is falling and ultimately negative gamma.

When gamma is positive, as it is more often is, the hedging behavior of option dealers - who take the opposite side of investors - represses volatility, as they must sell after the market rallies and buy after it sells off to rebalance their positions.

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