Short Gamma May Exacerbate the Current Rally

Sure, rallies like this are exciting, but on a medium-term view yesterday’s action doesn’t prove much. We’re still within the recent trading ranges on all the major indexes, and although markets have really taken any good news as an excuse to rally and have shrugged off bad news (except for GE, obviously), markets and market participants are fickle, so the sentiment could change at any time.

With only two days until expiration, there are undoubtedly some options sellers out there who are sweating today’s rally a bit. The reason? As expiration nears, the gamma of any options at or near the money is increasing exponentially, which means the more an underlying moves against you, the further in the hole you get in terms of directional risk, and (more importantly) the more impossible it becomes to reign in any front-month delta explosion.

That means if we get some more positive earnings news this week and the rally sees some follow-through, the short gamma hangers-on may only be adding powder to this particular keg. We saw the same phenomenon back at January expiration, just on the downside. That’s why it’s generally a good idea to get out of any risky or remotely near the money short contracts sooner rather than later; you can always keep your long contracts as lottery tickets, if you want.

Reversal Readings

The rally has pushed many names into overbought status. But we’re not looking at these as signals for short entries, since this is definitely a market that could move higher, and we’d rather wait for really extreme conditions in these readings.

• DIA, QQQQ, SPY, IWM - 96/97 area
• XLE - Energy - 98, new all time high!
• EWZ - Brazil - 98
• BND - Bonds - 3.31
• Plenty of readings in the 97-98 area, we’re looking for 99.xx before adding to short positions.

The VIX, now at 20.50, is the lowest it’s been in 2008, and plenty below its 200 daily moving average. The best performing volatility indexes? Ironically, the QQV and NDX.