To better understand the recent roller-coaster action of the stock market, I turned to a colleague who’s one of the world’s top options traders: Dr. Joe Duarte, chief investment strategist of Profit Catalyst Alert.

Dr. Duarte (pictured here) has been a professional investor and independent analyst since 1990. He is a former registered investment advisor and author of the bestselling Options Trading for Dummies, and several other books including Market Timing for Dummies and Successful Biotech Investing. My questions to him are in bold.

I’m getting queries from subscribers about this frustrating market. What’s going on?

No kidding. This is a frustrating market. But much of it has to do with the way the market itself works, deep in the bowels of the servers where the machine traders execute buy and sell orders.

And yes, it’s all the Fed’s fault (Laughs).

Everything is the Fed’s fault. How much control do the machines have?

In practical terms, the machines have all the control because they execute as much as 80% of the daily trading volume at the exchanges and other places like Dark Pools, which is where brokerages do off the book trades which are only reported to the market after they are executed. But Dark Pools are a deep topic which we can talk about some other time.

Well, how does all this stuff work?

It’s complex, but not complicated. If you break the process down into individual parts, each part is simple. It’s only when all the parts come together that you start scratching your head.

Sure. Give me an example.

Okay. When someone puts in a trade it goes to a market maker. This is a machine in a server somewhere in New Jersey, most likely. I used to live in Weehawken, which is rumored to house lots of bot market maker farms.

The trade gets executed by the machine and everyone goes about their business. Small numbers of trades with small numbers of shares usually don’t cause too much havoc. But when you have millions of trades going on at once, things get complicated.

What happens when things get complicated?

Suppose a big trader puts in a trade to sell 100,000 shares of Amazon (NSDQ: AMZN). The market maker sees the trade and executes the trade. But because the price of the stock starts to drop, the market maker buys put options on Amazon to hedge his account.

Market makers do this because their goal is to preserve the value of his account, along with making money on every trade by pocketing the spread, the difference between the Bid and Ask.

When other traders see that Amazon is falling in price due to the big trade, they start buying puts. The more puts they buy the more puts that market maker has to sell to those people buying puts.

To hedge his bets, the market maker starts selling stock index futures. This selling of stock index futures cuts the market maker’s potential losses but then leads to more selling as people see the market going down due to the market maker’s index future sales.

So, it’s like a vicious cycle based on options?

Yes. But here’s the shocker. The reason there is so much short-term volatility now is that options are the biggest influence on stock prices. It’s the reverse of what the system was designed to be, where stocks influenced option prices.

Is this what’s happening at the end of the day sometimes where prices fade after a nice rally?

Exactly. Anytime a rally fades during a trading session, you can bet that it’s related to ODTE options and the market maker’s response to an options play. This is especially pronounced in the SPDR S&P 500 ETF Trust (SPY) where there are daily expirations and the playing field is ripe for shenanigans.

And there’s more. Right?

Yeah. This has completely distorted the volatility structure of the markets. Because of the Fed’s rate hikes, everyone lives in fear of what could happen tomorrow, so they do this quite often just in case some Fed talking head says we’ve got to go “higher for longer” at some rubber chicken circuit lunch or dinner.

The new “hip” trade on Wall Street is One Day to Expiration Options (ODTE). That’s when traders buy put options that will expire on the next day. The sheer volume sometimes triggers market makers to respond in the same manner as above by hedging their account and selling stock index futures over short periods of time.

And what happens is that some days the market is rallying, but as the ODTE crowd comes in to hedge their overnight bets, the whole cycle starts and the rally gets crushed.

What can anyone do to manage this?

Once you know what goes on, you can use chart analysis to sort out what’s really happening. I use two indicators, Accumulation Distribution (ADI) and On Balance Volume (OBV) to help me understand what’s actually occurring under the surface of the market.

Do you use these indicators on Profit Catalyst Alert?

I use those indicators on every single trade that I recommend or execute for my own account.

Thanks Joe.

PS: Dr. Duarte has just pinpointed a tiny, unknown company that has developed a revolutionary “black box” technology. You need to get in on the ground floor of this game-changing opportunity before the investment herd finds out and sends the share price soaring. Click here for details.

John Persinos is the editorial director of Investing Daily.

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