For the second time in two weeks, today's Market on Close rebalance announcement at 350pm ET wreaked havoc on stocks. As we showed earlier, the publication of a notice that there were over $2BN in stocks for sale sending the S&P lower by 40 points in an unprecedented single tick.

This followed a similar but inverse reaction on March 26, when news of a $7BN MOC buy imbalance sent the S&P higher by 40 points in seconds.

Why is this happening? Simply, there is just no liquidity in the market, something we showed last week when we visualized the record bid-ask spread in the median S&P stock.

However, as it turns out, the collapse in equity liquidity which manifests itself in ever more violent moves during the end-of-day rebalancing, is having a far broader impact.

According to Goldman's John Marshall, single stock options prices have become overvalued as end-of-day re-balancing in a low liquidity market have exacerbated common measures of realized volatility. As the Goldman derivatives strategist explains, "realized volatility for the average stock appears 32 points higher than it is." This is how Goldman quantified the impact of what it calls the "end of day realized volatility premium":

We calculate the “end-of-day realized volatility premium” to quantify the distortion driven by end-of-day re-balancing activity during the period of low liquidity over the past month. We use the difference between close-to-close volatility and volatility calculated with VWAP as a proxy for the “end-of-day realized volatility premium”. The average stock in the S&P Top 100 has experienced a realized volatility of 120% using close-to-close prices over the past month, but has had a realized volatility of 88% using a daily VWAP over the past month.

This suggests an “end-of-day realized volatility premium” of 32%.

This is problematic as many market models, especially vol-targeting, use close-to-close volatility as a key input and are currently overestimating the fundamental volatility of stocks by 32% over this period. This has led to overpriced options across the volatility surface and inflated levels of risk aversion in volatility based risk models. In fact, Goldman finds that the ratio of 6-month implied volatility to 1 month realized volatility is positively correlated with this “end-of-day realized volatility premium” with a 30% R-squared across the names below.

One implication of this "rebalancing anomaly" is that typical measures of volatility are likely to decline faster than history would suggest according to Goldman, which expects close-to-close measures of volatility to decline faster than other metrics which incorporate intra-day data.

This is likely to drive a decline in implied volatility across stocks and indexes that seems more rapid than casual observers of options would have expected. Several factors needed to be present for the “end-of-day realized volatility premium” to develop: (1) fundamental driver of uncertainty, (2) low liquidity environment, and (3) investment products which require end of day re-balancing. We believe the liquidity environment is likely to remain challenging; however, we see potential relief from #1 and #3. We believe there has been some reduction in investment products that require daily re-balancing as many of these investors have de-risked following the sell-off. While it is difficult to say exactly when fundamental uncertainty will decline, we know it will pass with time.

Another implication is that single stock options are pricing moves over the next 6 months that are greater than moves YTD... which also means there is a way to profit from this peculiar arb.

Straddles on the average S&P 100 stock are pricing a move of 25% over the next 6 months. This is 4% larger than their average absolute return year-to-date. For 67% of the names in this list, 6 month straddle prices are greater than their YTD absolute return. Selling straddles on these stocks implies profit if the stocks are in a 50% range of +/-25% over the next six months.

Here, Goldman recommends selling straddles on names at the top of this list where the “end-of-day realized volatility premium” is the largest and likely to be inflating options prices. That said there is a risk, namely that straddle sellers risk 1-for-1 losses with stock moves in either direction that are greater than the premium collected.

Finally, for those readers who are not as versed in the nuances of greeks trading, here is a brief appendix explaining How low liquidity has inflated realized volatility, and why is it important for stock and option investors?