Why are US stocks sluggish? Blame a record $5 trillion options expiration

By Saqib Iqbal Ahmed

NEW YORK (Reuters) - An upcoming U.S. stock options expiration that is set to be the largest on record is tamping down market swings, potentially counterbalancing any gyrations stirred by the Federal Reserve's monetary policy announcement on Wednesday.

Some $5 trillion in U.S. stock options are set to expire on Friday, according to Asym500 MRA Institutional, a unit of derivatives strategy and execution firm Macro Risk Advisors.

While such events can exacerbate volatility, strategists say this week's expiration is likely to keep stock swings muted and may be one reason equities have traded in a tight range over the last few weeks.

The S&P 500 is up 20.6% this year, following an 12.5% rally from its October lows. More recently, however, market moves have been muted.

The benchmark index hasn't logged a greater than 1% move in either direction for 18 sessions, the longest such streak since early August. At the same time, the Cboe Volatility Index stands at 11.9, a near 4-year low.

Another example of the market's sluggish trading can be found in the ten-day realized volatility for the S&P 500 - or how much the index has swung over the last 10-sessions.

That measure stands at 6.8, after touching a low of 4.5 in late November. By comparison, it stood as high as 22.5 in March, when a banking crisis rocked markets.

The positioning of options dealers - who act as intermediaries between buyers and sellers of derivatives - has been one factor in keeping stock swings muted.

Exchange-traded funds that sell options to generate income have doubled in size this year and now control about $60 billion, according to a Nomura analysis.

To square the risk on their books, options dealers, who take the other side of these ETFs' options trades, have to sell stock futures when equities rally and buy futures when markets sell off. That has the knock-on effect of keeping stocks in a tighter trading range, market participants said.

The dealers' positioning "is more than likely to arrest any deeper selloff between now and year-end," Nomura strategist Charlie McElligott said in a note on Tuesday.

That could include Wednesday's Fed meeting. While the central bank is expected to leave rates unchanged, investors are keen for hints on whether policymakers are pivoting towards cutting rates sooner, an expectation that has fueled the rally in stocks this quarter.

Expiration is likely to loosen the options market's vice-like grip on stocks, said Brent Kochuba, founder of options analytic service SpotGamma.

Markets faced a similar situation two years ago, when a similarly large options expiration reined in volatility for part of the fourth quarter, only to give way to a 3% rally in the last two weeks of the year following the December expiration, he said.

"All that positive gamma is really crunching the market," Kochuba said. "The lid has been kept on volatility."

(Reporting by Saqib Iqbal Ahmed; Editing by Ira Iosebashvili and Nick Zieminski)