Why A Santa Claus Rally May Be Coming

The traditional Santa Claus rally, which typically occurs during the last five trading days of December and the first two of January, is driven by complex options market dynamics rather than holiday cheer.

Last Wednesday’s market selloff triggered a spike in the VIX (a measure of market volatility), influencing options in two key ways:

1. The overall price (premium) of both puts and calls increases due to higher implied volatility.
2. Options become more sensitive to stock price changes, as reflected in a higher delta.

Here’s an analogy: During normal market conditions, a $1 move in a stock might lead to a $0.50 change in an option’s price. When volatility spikes, that same $1 stock move could result in a $0.75 change in the option’s price. At the same time, traders are willing to pay more for these options because the potential for large price swings increases.

As markets stabilize and volatility decreases, several effects come into play:

• Options lose their elevated volatility premium (becoming cheaper).
• Their sensitivity to stock price changes (delta) diminishes.
• The “fear premium” embedded in put options particularly fades.
• Option sellers seize the opportunity to sell while premiums are still elevated.

Market makers, who facilitate these options trades, must constantly adjust their stock positions to maintain hedges. This process is influenced by the relationship between volatility and hedging needs (known as “vanna”). As volatility declines, vanna dynamics typically require market makers to buy more stock, even as options become less sensitive to price changes. This results in steady buying pressure in the underlying market.

The recent mini-panic caused an increase in option prices due to higher volatility premiums. Now, as fear subsides during the low-volume holiday period, option sellers are incentivized to sell these still-expensive options. As volatility continues to drop, market makers’ hedging activity will likely generate consistent buying pressure — the mechanical driver of the “Santa Claus rally.”

This interplay between declining volatility after a fear spike, option sellers taking advantage of elevated premiums, and market makers’ hedging requirements creates a favorable environment for upward price momentum into year-end.