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Traders Gauging Stock Market’s Next Move Keep Wary Eye on Flows

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(Bloomberg) -- The selloff that took the S&P 500 Index into a correction last week was notable for its relative calm. Now, as investors scour metrics of market sentiment and key price levels for hints of either a recovery or a further slide, they also need to watch a more nebulous aspect: market liquidity.

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Stock-market crises from the 1987 crash to Covid share a common theme: dried up liquidity intensified market moves. Now, with the rapid growth of derivatives, there’s a focus on how option positions affect underlying spot markets, especially given the tendency for derivatives blow-ups to linger in memory.

Volatility hasn’t spiked — the Cboe Volatility Index climbed steadily to near 30 before retreating even as shares kept dropping. And while intraday swings attracted day traders, S&P 500 put skews flattened and the VIX call-to-put ratio dropped, signs that some of the equities slide came from investors taking money off the table by selling both stocks and related option hedges.

While dealer hedging to adjust positions due to negative gamma from short option bets may have added some momentum at times, there hasn’t been an upswell of commentary about options having an outsized effect on the market. That’s largely down to liquidity, which has been mostly stable, according to one measure of market depth from the Chicago Fed and CME Group Inc.

“Liquidity is clearly key for underlying spot markets to absorb the flow generated from the option Greeks,” said Benedicte Lowe, equity derivatives strategist, and Georges Debbas, head of equity derivatives strategy Europe at BNP Paribas SA. “The main risk is when dealers turn heavily short gamma and liquidity is withdrawn and then you can see spot overshoot significantly.”

The declines in the S&P 500 have largely happened during regular trading hours, when liquidity is higher. And moves haven’t been due to a shock data point or announcement, but rather a steady drumbeat of tariff proclamations and trade bluster, much of which is walked back within hours.

While investors are rightly focused on levels of positioning in the S&P 500 — where more than $2 trillion options trade each day in non-delta adjusted notional — there’s $500 billion in front-month futures as well as a deep cash and exchange-traded fund market to absorb hedging flows in normal market conditions.