By David Gaffen
Jan 13 (Reuters) - U.S. stocks looked set to snap a two-day losing streak on Tuesday as trading moved into early afternoon.
Then, in the space of an hour, all the day's gains vanished in a spate of high-volume selling, leaving investors once again with concerns about oil, global growth, and all of the market's other persistent fears of late.
But what happened may have been more the product of activity in the options market than a shift in the outlook for fundamental drivers like profits and the economy.
The session started strong, with the S&P 500 up 1.4 percent at its peak. It faded fast, though, beginning around 1:15 p.m. (1815 GMT). When it was over stocks closed modestly lower, with the S&P enduring its largest swing from day high to low in three months.
Todd Salamone, analyst at Schaeffer's Investment Research, noted that heavy open interest in big "round number" contracts on the S&P 500's tracking ETF, the world's largest exchange-traded fund, was a likely culprit for some of the behavior. There are more than 189,000 contracts outstanding at the $205 level on the SPY - which corresponds to the 2,050 level on the S&P 500.
If the index closes above that level on Friday, when options expire, those call options are "in the money," and the market-makers who wrote the contracts will be forced to pay those investors who bought those contracts. Market-makers prefer to remain neutral to avoid such losses, and would have had long positions to hedge their risk.
But when the S&P started to cascade lower, the chances of the S&P closing above that 2,050 level by Friday started to diminish, allowing them to roll back their longs.
"The further out of a money the less sensitive the option is," said Salamone.
Then, just as those hedgers were shedding long positions, those brokerages who sold put options - or bets on a stock or index falling further - started to see a greater likelihood of the S&P closing below 2,000 by Friday.
With more than 354,000 put contracts outstanding at the $200 level, according to Thomson Reuters data, those market-makers suddenly face a real danger of taking a hit if the selling continued to worsen.
"As it gets closer to $200, more shorting activity may pick up and accelerate that move down," Salamone said.
Evidence of that worry was seen in heavy volume and volatility on Tuesday: S&P E-mini futures volume exceeded 2.86 million contracts Tuesday, the heaviest day of trading since mid-October, and the S&P's 49-point range was also the widest since October.
This activity doesn't happen in a vacuum, of course. With investors still worried that the falling oil prices suggest weaker-than-expected performance for the global economy, and ongoing uncertainty about Europe, there are plenty of reasons for investors to reduce positions in stocks.