There is more behind the recent slide in U.S. stocks than weak data, according to JPMorgan Chase’s head of quantitative and derivatives research, who says options hedging and technical selling contributed to the gyrations and could help the market reverse course and rally.
Even Friday’s modest positive move could spur technical buying and spell good news for equity bulls, Marko Kolanovic wrote in a note published as the market rallied on encouraging U.S. employment data.
The benchmark S&P 500 index shed 3% over the first two days of October, logging its worst two-day performance since early August, after employment and manufacturing data revived worries that the U.S.-China trade war is taking an increasing toll on the U.S. economy.
Dismal manufacturing data on Monday dragged the S&P down past several technical levels, prompting dealers who had earlier sold options to add to the selling pressure as they hedged their positions, Kolanovic said.
When investors buy S&P 500 put options, they are buying insurance against a drop in the market. Dealers who sell this insurance are on the hook if the index drops sharply.
To counter this exposure, they sell increasing amounts of S&P 500 futures as the index falls, thereby adding to selling pressure.
In addition to this options-related selling, the recent sharp drop in the S&P also prompted selling by commodity trading advisors (CTA) - firms that follow trends and are specialists in the futures markets.
“Technical flows likely drove more than about $100 billion of equities selling in a 48-hour period,” wrote Kolanovic.
However, that may be set to change.
The S&P gained 26.35 points, or 0.90%, at midday after September U.S. employment data offered some relief from the week’s spate of dismal economic indicators.
If stocks end the day more than half a percent higher, the near-term outlook would brighten significantly, Kolanovic said.
“It could spark a significant rally driven by the trend followers (CTAs) and the same put options that helped push the market lower earlier in the week,” he said