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Jeff Augen Market Review -5-20-2021 Last week’s 298 point round trip for the S&P highlighted important links between volatility trading, options gamma and delta trading at key strikes, and support /resistance levels for major indexes. Inflationary fears ignited the drawdown that continued through Wednesday when the S&P bottomed out at the most heavily traded put strike (4050) in terms of net gamma. As the market touched this key support level, volume in the VXX ETF tripled as volatility traders rushed in to short the peak at $49.57. The term structure of volatility also reversed quickly after barely dipping into the negative range (-4% spot VIS versus September VIX future). The simple fact that volatility term structure never inverted steeply throughout the selloff was a sign that institutional investors were setting up for the next rally (large drawdowns often invert beyond -20% over a 3-month timespan). The reversal turned into a sharp rally Friday, driving the S&P up through a major gamma resistance level at 4150. This level first became important on Tuesday when the S&P traded around this strike throughout the day, opening at 4150 and closing at 4152. High volume on both the put and call side sharply increased the open interest at this strike, creating a price magnet. At the same time, trading intensified around the 4175 strike, paving the way for another brief rally. This week’s monthly expiration will set the trend for the next several weeks after institutional investors adjust their option portfolios around new strikes. We can gain some insight by comparing open interest for near-the-money puts and calls. At a delta of 0.20, open interest for S&P puts is approximately 13X that of calls for this week’s monthly expiration. This large distortion, created by the recent drawdown, will evaporate in Friday’s expiration. However, the same measurement still yields a surprisingly large put/call ratio of 4X for next month’s expiration. These unusual options market dynamics fit with a report from Goldman showing that its Prime Book was net sold with short sales outpacing longs 2.4 to 1. Info Tech led the trend with short selling reaching its highest level in more than 5 years. Whether this overwhelming imbalance will end in a correction or a short squeeze rally will depend heavily on this week’s expiration. Investors know that uncertainty regarding inflation is the driving force underneath these complex dynamics with the word “transitory” at the center of the discussion. The Fed believes that inflation will subside because the members know that the economy is currently propped up on a foundation of emergency pandemic relief payments that will soon end. The math is relatively simple. GDP grew at an annualized rate of 6.4% with 8.1 percentage points coming from consumer and government spending while the other categories subtracted 1.7 percentage points from the total. In summary, the U.S. is currently borrowing and/or printing 100% of its posted economic growth. Understanding the numbers and listening to statements from Fed officials leads to the inescapable conclusion that no action will be taken to slow the money supply growth until the Fed has been able to observe solid economic performance for a sustained period of time after the current emergency relief programs expire in September. It is also important to remember that the Fed’s most recent Financial Stability Report lists vaccine-resistant COVID variants as the greatest risk factor to the economy. That analysis is on target because new vaccine escape mutations continue surfacing around the world with no clear medical solution on the horizon. Financial markets are beginning to comprehend these dynamics which can be summed up as cost-driven inflation and an economy struggling to regain its footing at the top of the largest investment bubble on record.