Delta, gamma and month-end flows

Option hedging: delta and gammaThe flow of option hedging is the first significant cyclical effect on equity markets. Say investors (that's you and me) own a lot of S&P 500 put and/or call options bought from market makers, and the market is falling. Market makers must sell the index to hedge their exposure (delta hedging), which creates additional selling pressure. In a rising market these hedging flows are inverted.

The effect is exaggerated the closer we get to expiration, as gamma effects increase. Once the options expire, the dealers' immediate index exposure ends, which removes the directional pressure and causes the market to reverse. Historical data supports this explanation: the S&P 500 is more likely to change direction on options expiry.

Month-end rebalancingThe second significant effect is month-end flows, which are rebalancing flows. After stocks have fallen, most asset allocation models rebalance by buying stocks at month-end to return to their target weight (and vice versa). These flows run counter to the recent market trend. Historical data indicates that the S&P 500 is more likely to rise (fall) into month-end after a large price decrease (increase) in the index, which supports this explanation.

TogetherBoth effects are most likely at work. Their combined effect produces intra-month mean reversion, which smooths monthly returns.