Both traditional and decentralized markets face unique challenges from well-capitalized traders who, through their opinions, can influence illiquidity and volatility.

The recent S&P 500 futures movement presents a case study:

1. Markets seemed uncertain, and large traders, reportedly including Carl Icahn, accumulated significant positions in 4050 puts.
2. The market declined to precisely 4050 by expiration.
3. Subsequently, these traders established new positions in 3950 puts for the following month.
4. And sure enough - the market dropped again.

What is the relationship between these large options positions and the market movements? While it's difficult to prove causation, the mechanics of dealer hedging combined with market psychology can create conditions where large derivative positions influence the price action of spot assets. These traders likely took advantage of the market signals and the prevailing negative sentiment leading into those option expirations.

Market Structure

Market Structure encompasses all market characteristics, such as the number and size of buyers and sellers, competition level, information availability, regulatory environment, and the physical and virtual infrastructures where financial instruments are traded. These can all affect market efficiency, price discovery, and overall price trajectory.

During Covid times, 'gamma squeezes' became a colloquial term on financial news channels. They represent the phenomenon of dealer positioning (Gary), an inevitable result of how equity markets are structured. In short, a 'gamma squeeze' occurs when the acceleration of upside derivative purchases increases, leading to the purchasing of the underlying by cash-heavy dealers, resulting in exponential rises in price, as seen in Gamestop and AMC. When you buy derivatives that profit on the upside of an asset (going long), a dealer can sell you the derivative (going short) and hedge against that by buying the underlying asset.

When the acceleration of upside derivative purchases increases, so does the purchasing of the underlying by cash-heavy dealers, resulting in exponential rises in price, as seen in Gamestop and AMC. Monitoring the call or put volume before a gamma squeeze could give actionable insights on how to trade it.

Consequences of 1987

How can these dealers be so involved when they impact the market so much? The answer is liquidity. Some market-making dealers are legally obliged to place bids under specific market conditions. This is meant to protect the infrastructure and price stability of the underlying and became standard practice after the 1987 crash, which resulted from an overcrowded trade in portfolio insurance. Some traders like Paul Tudor Jones made a killing by being on the right side of this and once the dust settled, the US market nearly went up only until the tech bubble burst in the early 2000s.

The 1987 crash was a technical reaction to how the market was structured. There was no fundamental change that provoked the price collapse. Simply put, there were not enough market-making firms willing to place a bid on that frightful morning, and regulators deemed that unacceptable, so market makers have since become one of the primary driving forces of global markets.

The arguably black swan events of 2008 and 2020 were two moments when this market-making backstop failed. In both cases, price conditions were so dire that there seemed to be no buyers left—until the central banks made their money-printing intentions clear, as they have time and again.

Notional Value vs. Real Value

Below is a graph of the S&P 500 index (traded as /ES) priced in USD.

Now, compare the index against the Fed's balance sheet.

As you can see, the index's value in 2007/2008 was around 0.0016. So, for every $1 on the Fed's balance sheet, ~$0.0016 of value existed in the S&P 500 index. Quantitative easing and bank bailouts brought floods of new capital into the system and onto the Fed's balance sheet, pushing the index's value to the $0.0004/0.0006 territory.

The index has not come close to its previous highs in relative real value. Meanwhile, the USD notional value is steeply rising. In other words, prices are rising. Real value can be measured by a notional value less inflation, which results in spending power, but how do we measure inflation? You can listen to what the Fed reports in its CPI numbers or measure your purchases.

Candy is not a Store of Value

| Product | 2014 Weight | 2018 Weight | Change | | ------------------------ | ----------- | ----------- | ------ | | Snickers (4 pack) | 232g | 167g | -28.1% | | Toblerone Milk Chocolate | 200g | 150g | -25.0% | | Twix Twin Bars (4 pack) | 200g | 160g | -20.0% | | Kit Kat Chunky | 48g | 40g | -16.7% |

The notional value of these candies has not changed, yet the real value of what you are purchasing has declined substantially. This pattern of decreasing returns and increasing prices is typical across many industries, such as education, groceries, commodities, ride-sharing services, and streaming platforms.

Variables

Asset Scarcity

Scarcity, physical or digital, has made its way to the front lines of the debate on asset valuation. One thing is certain: the US dollar is not scarce, nor are the derivatives tied to it. According to Visualise Capitalist's research on the world's money supply, the global derivatives markets outside the world's stock markets by a factor of 11. A conservative estimate of the notional value of the world's derivative markets is one quadrillion US dollars.

If that estimate is correct, then for every $1 in a stock market, $11 in derivatives are betting on what that $1 does. These $11 serve various purposes, such as supply-side hedging, but most are cash-settled speculations. These are side bets, bets on side bets, and bets on bets on side bets. Each carries its own risk profile but is ultimately tied to that first $1.

The thesis is that the sheer quantity of side bets changes how the initial bet plays out. This is similar to the reflexivity principle discussed by George Soros in his book The Alchemy of Finance or Gary's concept, described by TV-friendly market maker and fund manager Cem Karsan. Mimetic desire is probably in there, too.

Reflexivity

Physicists deal with the same issues of reflexivity as financial markets, but in a more fundamental sense — the observer effect.

"In physics, the observer effect is the disturbance of an observed system by the act of observation. This is often the result of instruments that, by necessity, alter the state of what they measure in some manner. A common example is checking the pressure in a car tire. It's difficult to do without letting out some air, thus changing the pressure. Similarly, it is not possible to see any object without light hitting the object and causing it to reflect that light. While the effects of observation are often negligible, the object still experiences a change."

Financial markets are dynamic entities with an infinitely complex combination of observers and their intentions. The use of derivatives compounds this observer effect.

Crypto Derivatives

The whales in the equity markets are traditionally risk-averse, such as endowments, pension funds, and even market makers. In contrast, the whales in crypto are often early adopters playing with house money, family offices, emerging funds, or individual traders with larger risk tolerances.

These dynamics create sustained volatility unmatched in traditional equity markets, aside from penny stocks or OTC stocks where market caps are small, and majority share owners can, at least temporarily, get away with acting shady to pump or dump prices.

Crypto derivatives are niche compared to equity derivatives, and their notional value is far lower. The existence of multiple crypto futures exchanges, funding rates, on-chain activity and other factors further muddy the water. For example, there have been times when Bitcoin futures traded 10% higher on Coinbase than on different exchanges. This doesn't happen to SPX futures on the single exchange where all /ES futures contracts are traded. Bitcoin's premium has been as high as 20% in South Korea due to restrictions on foreigners trading the South Korean Won — it eventually gets arbitraged out or resets to equilibrium, but that is a non-existent phenomenon in equity markets and shouldn't happen.

Outcome

Markets are shaped by their structure, and the interplay of big players, liquidity, and reflexivity frequently contribute to price movements and volatility. The ratio of fundamental to market-related movement is something worth exploring.