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I am not able to get technical/logical reason behind following scenario. Can you please help me to explain the reason behind it?

Context:

Group of stocks makes the index. It means Index is dependent on stocks, right? Index future is dependent on Index. Also, Index PUT & CALL options are dependent on Index.

Confusion/Question:

When we say there is short covering in CALL options, then index moves upwards.

And when there is long unwinding in PUT options, then index moves downwards.

I’ve heard this, and also experience this.

But how index PUT and CALL options writing/unwriting affects index ( internally stock prices)? Index and PUT/CALL options are separate entity. There can be premium/discount compared to index. But how they can affect index price?

I’m not able understand technical/logical reason behind it.

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  • "we say there is short covering in CALL options, then index moves upwards" who says this? Do you have a link so we can see the context?
    – D Stanley
    Nov 28, 2022 at 13:36
  • "Short covering" means people are short and they want to go back to normal so they buy the shock. Not sure precisely how it relates to options.
    – user253751
    Nov 28, 2022 at 17:25

3 Answers 3

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Options do not directly affect the index. The index is just the weighted average of the stock prices within it. That is all.

There might be some secondary effects as options on the underlying stock are exercised, but options are more often sold (or bought) to close rather than being exercised, since it's generally more profitable to do so. But exercising an option on stock would create a marginal amount of buying/selling that could affect the index, but not dramatically. It would be no more of an effect as individual investors buying or selling stock.

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  • With all due respect, this answer is incomplete at best.
    – 0xFEE1DEAD
    Nov 28, 2022 at 14:49
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It has to do with dealer hedging.

When a market maker sells call options, they're short delta/gamma. As the index rallies, delta gets shorter and they need to buy more futures to cover their delta, which drives the index up further.

Conversely, if they sell put options and the index sells off, their delta gets longer and they need to sell futures to stay delta-neutral, leading to a vicious cycle.

Similar price action can be observed when clients close out large long/short call/put positions or because of the monthly/quarterly expiry.

Futures activity impacts cash equities since any differences are arbitraged away, i.e. futures vs ETF, ETF creation/redemption vs stocks.

Here's a recent example (Bloomberg Archive):

A looming $3.2 trillion options expiry played a notable role in the Tuesday selloff.

As a hotter-than-expected inflation reading rocked Wall Street, a slew of bearish options that had become worthless during last week’s rally jumped back in the money, forcing market makers to sell underlying stocks to hedge their positions.

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    Are you talking about the index itself or funds that track the index? The index is just a calculation of the stock prices within it, nothing more. There may be tracking error based on hedging, but that's the fund, not the index itself.
    – D Stanley
    Nov 28, 2022 at 14:35
  • @D Stanley I'm talking about the hundreds of thousands of SPX options contracts that are traded each day, not to mention Total Return Swaps (TRS) and other derivatives, which all need to be hedged with futures. Futures activity has an impact on the index and cash market, since they're closely linked.
    – 0xFEE1DEAD
    Nov 28, 2022 at 14:54
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    We may be splitting hairs a bit, but I would call that secondary effects since they affect the value of the stocks that are bought and sold, which affects the index. The index is simply a weighted average of stock prices, and is not directly affected by any derivatives on it.
    – D Stanley
    Nov 29, 2022 at 0:24
  • @DStanley fair enough but a lot of commentators make the same shortcut, which is what OP is asking about.
    – 0xFEE1DEAD
    Nov 29, 2022 at 0:36
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Options can have a significant impact on the performance of an index. When options are used as part of a trading strategy, they can be used to hedge against market risk and to speculate on the direction of the index. If the options are correctly used, they can help to reduce volatility in the index and increase returns. However, if the options are misused, they can lead to losses and increased volatility. In addition, options can also create liquidity in the market. This can help to reduce the cost of trading, as well as increase the efficiency of the market.

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  • "If the options are correctly used, they can help to reduce volatility in the index and increase returns." Please elaborate.
    – 0xFEE1DEAD
    Nov 28, 2022 at 23:52
  • Options allow investors to purchase the right to buy or sell an underlying security at a predetermined price, at a predetermined date in the future. This means that the investor can protect themselves against losses due to market fluctuations. If the options are correctly used, investors can gain exposure to the market without taking on too much risk. Additionally, options can also be used to generate income, as the investor can collect a premium for selling the option. This can be beneficial in increasing returns, as the premium income can offset any losses from the underlying security.
    – Lis Cantal
    Nov 29, 2022 at 0:06
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    This has nothing to do with the value of the index.
    – D Stanley
    Nov 29, 2022 at 0:22
  • @LisCantal I think we all know what an option is. However, this doesn't answer the question...
    – 0xFEE1DEAD
    Nov 29, 2022 at 0:24

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