Option cycles explain intra-month cycles in equity markets

The US indices Nasdaq100 and S&P500 made new all-time highs on Monday, gaining 1.46% and 0.85% on the day. Last week’s drawdown was bought back as quickly as it was in the last several months.

The daily charts of the S&P500 clearly show how the American market indices have been falling over the last year by the expiration date of the monthly options (third Friday of the month). In the meantime, explanations for market movements due to fears of increased illness or a sell-off are falling by the wayside.

The monthly options cycles explain the market development much more than the other reasons, which is somewhat scary. Previously, this connection was difficult to isolate, but it shows up much clearly near market extremes.

Since last September, it is obvious to see how technical the chart has become: there is deterioration in the performance of equities in the days before the expiry. For the last four months, like clockwork, the S&P500 has fallen towards its 50-day average by the time of the options’ recharge and received actual support near the third week and the beginning of the fourth.

The impact of option life cycles could become stronger next month when there will also be a quarterly futures expiry.

The intensification of this correlation in the markets indicates an increased propensity for professional speculators, who widely use options on equities and indices to hedge risks.

This correlation is clear evidence of an overheated equity market, which makes for fragile conditions. But it is not enough to take short positions right now. There are enough fundamental positives in the markets (economic boom, tight labour, ultra-soft monetary policy) to buy short-term drawdowns.

The said correlation can break at any moment, and it is very dangerous to rely on it as a permanently working model. Instead, it is a reason to pay attention to the timing of market drawdowns and demand – whether they intensify after expiry.

Interestingly, in the FX market, although the dollar is under some pressure on rising equities, the DXY has maintained an uptrend since June with a strengthening of buying on the decline towards the 50-day average.

The two trends rarely coexist for long, so it is worth keeping a close eye on which one will take the upper hand, and it is often the case that turning points are better seen in the currency market rather than the stock market.

The FxPro Analyst Team