Seasonal Vol Selling Meets Tightening Liquidity
This was initially produced for Navigating the Markets members on December 19, 2025. Free commentaries will return on January 5. I hope everyone is enjoying the break. Looking forward to the new year!
-Mike
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3 Takeaways
Expect volatility-selling to dominate near-term price action, as holiday-shortened weeks historically suppress implied volatility, even if fundamentals are not supportive.
Watch the Japanese yen and cross-currency basis swaps closely, as a reversal in yen weakness could pose a material risk to U.S. risk assets.
Prepare for wider trading ranges after OpEx, as reduced gamma and tight year-end liquidity increase the probability of sharper moves next week.
Observations
A setup into next week hinges almost entirely on implied volatility selling rather than supportive liquidity or hedging flows. If volatility sellers successfully suppress implied volatility despite rising realized volatility, equities could grind higher into year-end. However, any sustained strengthening of the yen or further tightening in dollar funding conditions would significantly challenge that bullish outcome.
I noted in the video the BOJ had a hawkish “cut”; I should have said hawkish “hike.”
Fully Edited Transcript by ChatGPT
Hi, everyone. Today is Friday, December nineteenth, and it’s options expiration day. I generally don’t like to focus too much on OpEx because there are a lot of different games that can be played. Options are obviously a much bigger part of the market today than they used to be, so they need to be respected, but there’s also a tremendous amount of noise on days like today. For that reason, I don’t put too much emphasis on it.
What we’re seeing today largely looks like mechanical volatility selling. The VIX is currently around 15.3, which is interesting because that’s getting close to the lower end of its range. That, in itself, makes next week more interesting. Next week is obviously a holiday-shortened trading week, and historically the market tends to short volatility during shortened weeks.
The issue this time, compared with Thanksgiving, is that during Thanksgiving volatility was nearly 12 points higher. Now volatility is already at the low end of its range. So while volatility could still be sold and the market could push higher next week, I don’t know that there’s the same ability to push it as far as we saw during Thanksgiving. It’s difficult to predict how large a move could be. That said, Wednesday is a half-day for Christmas Eve, Thursday is a market holiday, and Friday brings a shortened week dynamic into the weekend. That certainly opens the door to volatility selling.
Then we move into New Year’s week. The market is open on December thirty-first, closed on January first, and then resumes. There’s ample opportunity over the next week or two for volatility selling, and I don’t think that should be discounted. Volatility selling is a major part of daily market activity, and we’ve seen it repeatedly. I underestimated its power during Thanksgiving because there were other forces at work, particularly liquidity tightening.
There’s a very good chance that next week begins with volatility selling for at least part of the week. From a technical perspective, the S&P 500 has strong resistance around 6,850, and above that you’re looking toward 6,890 if volatility can be suppressed enough. One thing standing in the way is that realized volatility is rising as the market rises. Nine-day realized volatility is now around 11.3, and a one percent move in the S&P would suggest nine-day volatility moving toward 16. Rising realized volatility makes it more difficult to suppress implied volatility, which is another challenge.
From a timing standpoint, the setup looks similar to prior periods where volatility selling emerged, but mechanically the market is not in the same position. They may attempt it, or we may simply remain in a tight trading range. It’s something to be aware of.
Looking at the S&P 500 setup, it reminds me of the end of last year and also of late 2021 into early 2022. In late 2021, there was a sharp sell-off in November, a rally, another sell-off in mid-December, and then a strong rally into late December before topping out in late January. The current structure isn’t all that different, with an October peak, a pullback, another peak in November, another low, and then a rally back.
What we’re likely seeing now are the effects of liquidity being pulled out of the market over the past couple of weeks. When you look at the Nasdaq, there’s room for it to move back toward 25,600, the 78.6% retracement level, but it’s clearly in a weaker position than the S&P 500.
If you’re bullish next week, volatility selling and seasonal effects could be a tailwind. Outside of that, from an equity standpoint, there isn’t much else driving markets between now and New Year’s. Today is mostly about options expiration, and I expect trading ranges to expand next week as gamma exposure declines.
What’s more important today is what’s happening with the Japanese yen. The yen is weakening materially against the dollar and against most major currencies. It’s notable because this is happening even after the Bank of Japan raised rates by 25 basis points. Initially, the move was viewed as hawkish, since Governor Ueda indicated real rates remain deeply negative. However, he didn’t commit to a timeline for further hikes, which the market appears to be interpreting as permission to short the yen.
There could also be mechanical factors at play, such as volatility unwinds in FX markets following central bank events. If that’s the case, some of today’s moves could reverse next week.
Japanese rates have risen notably over recent days. The two-year is around 1.08%, the five-year near 1.48%, the ten-year around 2.02%, the twenty-year near 2.97%, the thirty-year around 3.42%, and the forty-year near 3.73%. Many of these moves occurred just today.
In the U.S., yields are also moving higher, with modest steepening of the curve. More importantly, the spread between U.S. and Japanese yields continues to compress. The U.S. ten-year minus Japan ten-year spread is now around 212 basis points, and the five-year spread is near 221. These dynamics suggest the yen is becoming increasingly stretched relative to interest rate differentials.
Five-year yen forwards are around 17.60. They haven’t broken out yet, but they’re close. At some point, the yen won’t be able to continue weakening if rate differentials keep compressing and forward rates keep rising. I suspect we eventually see the yen strengthen materially, and authorities may become concerned enough to consider intervention.
We’re also seeing the five-year cross-currency basis swap narrow to around negative 39.8 basis points. These levels are extreme, not seen in roughly a decade, and suggest limited dollar hedging demand so far. If the dollar begins to weaken against the yen, we would expect increased dollar demand and further movement in these swaps. Historically, changes in yen funding and dollar demand have correlated with moves in the S&P 500, even if imperfectly.
If dollar funding costs move sharply lower and basis swaps become significantly more negative, that would pose a major risk to U.S. risk assets. That’s been the trade dynamic going back to at least 2016.
Elsewhere, high-yield credit spreads are relatively flat today, which is notable given equity performance. Equity repo financing, measured via BTIC contracts, is diverging meaningfully from equity prices. Across January, March, June, and out-year December contracts, financing demand is falling sharply. This suggests demand for equity funding is collapsing, and this doesn’t appear to be purely seasonal.
Dispersion has also unwound significantly. The dispersion index has fallen back to its starting point, while correlations have not risen to the same extent. Index constituent volatility has come down, compressing spreads. Zero-DTE trading is likely helping keep index levels elevated despite sideways price action.
Next week is a short trading week with significant settlements: roughly $28 billion next Friday and $88 billion on December thirty-first. Liquidity will be tight into year-end. Overnight funding rates have firmed, and forward expectations suggest SOFR could approach 3.80% by December thirty-first, alongside potential usage of the reverse repo facility.
Liquidity conditions are likely to remain tight, including in cross-currency markets. There’s a reasonable chance the yen begins to strengthen after today’s moves settle. From a bullish perspective, implied volatility selling is really the only supportive factor heading into next week. As we saw during Thanksgiving, it can override many other forces—but we won’t know if that dynamic takes hold until Monday.
Today, I’m largely chalking up market action to options expiration and not reading too much into it. We’ll see how next week evolves. Have a great weekend, and we’ll talk again soon.
Defined Terms and Jargon by ChatGPT
OpEx (Options Expiration): The date when options contracts expire, often associated with increased volatility and mechanical trading effects.
Implied Volatility (IV): The market’s expectation of future price volatility, derived from option prices.
Realized Volatility: The actual historical volatility observed in asset prices over a specific period.
Gamma: A measure of how sensitive an option’s delta is to changes in the underlying asset price; high gamma can suppress price movement.
Volatility Selling: Strategies that profit from declining implied volatility, often by selling options.
Cross-Currency Basis Swap: A derivative reflecting the cost of swapping one currency’s interest rate exposure for another’s, often used to gauge dollar funding stress.
BTIC (Basis Trade at Index Close): A futures-related financing mechanism reflecting demand for equity funding.
Dispersion Trade: A volatility strategy that exploits differences between index volatility and individual stock volatility.
Zero-DTE Options: Options that expire the same day they are traded, increasingly influential in intraday market dynamics.
SOFR: Secured Overnight Financing Rate, a benchmark for short-term U.S. dollar funding costs.
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