The stock market is already prepared for the Fed to lift interest rates, making a sell-off unlikely next week
As if we didn't have enough to worry about thanks to the imminent, most publicized Fed rate hike ever. Will Fed + put options = big sell-off? J.P. Morgan seems to think it could.
"Analysts at JPMorgan Chase say the Federal Reserve has 670 billion reasons to deliver a 'dovish hike' if it elects next week to raise interest rates for the first time in nine and a half years.
"... 'This important event falls at a peculiar time -- less than 48 hours before the largest option expiry in many years,' wrote Kolanovic, noting that $1.1 trillion worth of Standard & Poor's 500-stock index options -- of which $670 billion are puts -- will expire on Dec. 18. Roughly one-third of the puts poised to expire are at or near the money, with strike prices from 1,900 to 2,050.
"'Clients are net long these puts and will likely hold onto them through the event and until expiry,' the strategist wrote. 'At the time of the Fed announcement, these put options will essentially look like a massive stop loss order under the market.'"
Sounds terrifying! But it doesn't really make any sense as a bearish take.
If the options act as a stop-loss, isn't that bullish? Investors long puts now have ammo to buy futures, SPDR S&P 500 ETF Trust (SPY) shares, etc., into weakness, and last I checked, more buyers help support prices. Further, they probably start buying before it gets there.
Lots of stops in the general sense are bearish, in that once the futures get to a certain price, the stops get triggered, thus adding to the selling pressure. But this is totally different. They already have built-in stops; they don't actually have to sell anything.
On the other hand, options are a zero-sum game. Thus, if there are lots of put longs out there, there's an exactly equal quantity of put shorts out there (I'm talking contracts, not players). They have the exact opposite experience. They get long if the S&P 500 Index (SPX) gets through their strike, and that has the effect of adding selling pressure on top of selling pressure.
The real question is who has control. Public holders are considered weaker, in that they have shallower pockets. But professional investors/traders are more likely to actively hedge. Thus, if the SPX does break below high open interest strikes and it's very near expiration, we could indeed see a cascade effect. J.P. Morgan might be right, but for almost the exact opposite reason that they lay out here.
Having said all that, I'm really skeptical we see a major sell-off on news that's so expected. Markets hate uncertainty and surprises. I think you can make more of a case that no action will beget some ugliness, since very few are positioned for it.
Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.