ACTV - The Bulls Are Trapped With Nowhere Left To Run

2023-04-20 11:45:14 ET

Summary

• The April options expiration has pinned the market between 4,150 and 4,200.
• This has the bulls trapped because advancing beyond 4,200 will be extremely difficult.
• The odds favor implied volatility rising from here. At the same time, liquidity is being sucked out of the market.

The bulls are trapped with nowhere to hide, as Friday's April Options expiration potentially serves as a pivot point for the market. Couple this with a VIX index hitting its lowest levels in a year, and liquidity now leaving the markets, it could make for a very rough ride.

As we near the April options expiration date, the bulls face limited options. Liquidity is starting to drain from the market, just as implied volatility reaches its lowest level since January 2022, reducing the likelihood of the bulls advancing the S&P 500 ( SP500 ) and Nasdaq 100 ( NDX ).

April Options Expiration Caps The Market

The stalling out of the S&P 500 and Nasdaq 100 is mainly due to options positions and gamma levels. The S&P 500 is being kept from advancing beyond 4,200, and the QQQ ETF ( QQQ ) is from moving past $320 due to these factors.

The concentration of gamma in the S&P 500's largest open interest positioning region is at 4,150 and 4,200. These levels prevent the S&P 500 from rising or falling due to market maker hedging activities. However, as calls and puts lose value as options expiration approaches, market makers will unwind hedges. By Monday, the market will be free to move in any direction.

Similarly, the QQQ ETF also is affected by options positions and gamma levels, with the most significant open interest regions at $315 and $320. This is having the same effect on the QQQ. As a result, the Nasdaq 100 has not been able to move higher since the end of March.

I talked about the importance of the 4,200 level in a recent appearance on Making Money with Charles Payne on Fox Business.

Implied Volatility Is Not Likely To Stay This Low

The market's most significant challenge after Friday will be the uncertainty surrounding the next Fed meeting on May 3. Although the market predicts a 90% chance of the Fed raising rates by 25 bps at that meeting, what follows is highly uncertain. Currently, the odds are increasing for a June rate hike, and a May hike, but the probability of two rate hikes remains low. The May press conference and FOMC statement are likely to be ambiguous and offer little reassurance to the market about what will happen next and will work to increase implied volatility.

The VIX term structure has significantly steepened recently, with the spot VIX falling to 17. While the market has been lowering the VIX at the front of the curve, the back of the curve has remained relatively flat and within a much tighter range.

The spread between the spot VIX and the 3-month VIX futures contract is -5.7 points. Since the beginning of the bear market in January 2022, whenever the spread has reached -5 or lower, it has coincided with a peak in the S&P 500 and a significant decline. This pattern was observed in January, March, August, and December and may potentially be the case at present.

Liquidity Drain

Another market headwind is the liquidity drain as the Treasury General Account rises and reverse repo facility usage increases. These liabilities are on the Fed's balance sheet and remove excess liquidity from the market. The TGA had been depleted to around $100 billion, but with the influx of tax receipts, it has risen to about $250 billion and is expected to continue growing in the coming days.

The recent surge in money market accounts appears to flow into the reverse repo facility, with usage approaching $2.3 trillion daily. As we approach month-end, use typically increases as government-sponsored entities park some of the cash they have collected throughout the month in the facility.

The rise in the TGA and reverse repo facility should result in falling reserves. Additionally, the decline in discount window usage and the return of loans from foreign officials to the Fed, in conjunction with quantitative tightening, should reduce the size of the balance sheet.

Based on my reserve balance modeling, current reserves are estimated to be around $3.2 trillion. Still, this number is likely to decrease in the coming days. It may fall below $3.0 trillion over the next few weeks, effectively removing all the liquidity that entered the market following the Silicon Valley Bank rescue.

Historically, reserve balances of $3 trillion are equivalent to an S&P 500 trading range of 3,800 to 3,900.

The apparent "strength" in the stock market should not be mistaken for actual strength. It's related to options hedging, which may disappear once options expiration passes. Then the market will likely shift its attention to the May FOMC meeting, resulting in higher implied volatility while liquidity is drained.

Buckle up.

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