Deep within the underbelly of the options world lies a threat to the stock-market calm that’s prevailed all year.
(Bloomberg) — Deep within the underbelly of the options world lies a threat to the stock-market calm that’s prevailed all year.
While benchmark indexes just limped to one of their smallest weekly changes of 2023, intraday moves tell a different story. Up-and-down swings in the S&P 500 are the widest since June and double what they were last month. Twice in the past six sessions the index’s futures erased a 0.9% gain, the first time that’s happened since February.
While uncertainty about the economy and central bank policy was one instigator, something else may be contributing to the volatility: Market makers repositioning their exposures. There’s evidence that these Wall Street dealers — with the capacity to move millions of shares to hedge their books — have shifted to a posture where their selling has the potential to exacerbate market swings.
Any turbulence is likely to be temporary and betting against price swings remains a popular trade. But this change in dealer positioning is a departure from the first seven months of the year when the cohort played a major role curbing price swings, according to a model kept by Goldman Sachs Group Inc.’s managing director Scott Rubner.
“Market moves are exacerbated, and no longer muted,” Rubner, who has studied flow of funds for two decades, wrote in a note Thursday. “This is new.”
Stocks fell for a second week as a mixed bag of inflation data added to an already heated debate about whether the Federal Reserve is finished hiking rates and how long the economy can avoid a recession. The S&P 500 slipped 0.3%, while the Nasdaq 100 capped a two-week retreat in which it has fallen 4.6%.
For the five sessions through Thursday, the S&P 500 posted an average intraday swing of 1.1% — the widest gyration since June, data compiled by Bloomberg show. While the oscillation pales in comparison to 2022’s bear market, it’s almost double the average daily move from just two weeks ago.
“There’s still the potential for soft landing and there’s still a potential for like a consumer retraction, which leads to a corporate profit contraction,” said Tom Hainlin, national investment strategist at US Bank Wealth Management. “People are trading on the two range of outcomes, so you’ve just got this push and pull.”
A potential accelerant in the process is captured by the concept known in derivatives parlance as gamma, or the theoretical value of stock that option dealers must sell or buy to hedge against the directional risk resulting from price changes in the underlying assets.
To be sure, getting a clear read on the interplay between the vast derivatives universe and the underlying shares isn’t easy. Oftentimes, models built on subjective assumptions spit out different numbers on how much market-maker hedging is required in a given scenario. While not an exact science, such analysis offers a lens into the potential impact from the complex derivatives world on the cash market.
And right now, two widely followed Wall Street trading desks are sounding alarms over potential turbulence on the horizon as option dealers move away from their “long gamma” position — a status that previously obliged them to go against the prevailing market trend, selling stocks when they go up, or vice versa.
By Goldman’s model, the group’s exposure to S&P 500 options flipped this week to negative for the first time this year, while that for all index contracts was the most short since last October.
The shift was also detected by a Morgan Stanley team led by Christopher Metli, who flagged dealers’ exposure plunged more than 80% from a few weeks ago. The pullback, the team observed, coincided with a slowdown in volatility selling — the kind of activity increasingly driven by exchange-traded funds that sell call contracts for income.
That, combined with the activity of leveraged ETFs right now — those employing derivatives to generate performance that’s multiple times that of the underlying asset — means the market is susceptible to larger moves, according to the Morgan Stanley team.
“The Street will sell into a down tape and buy into an up tape,” they wrote. “This is likely temporary – but for now, it leaves the market free to move.”
There are signs that traders are hesitant to bid up stocks after a 10-month, 28% rally pushed the S&P 500’s price-earnings ratio to elevated levels that were reached only twice in the past three decades. Funds focusing on US stocks just had their first outflow in three weeks, according to Bank of America Corp., citing data from EPFR Global.
Down almost 3% into August, the S&P 500 is off to its worst start of a month since March. The retreat, if it continues, could prompt an exodus from systematic money managers that make asset allocation based on volatility and momentum signals, according to Goldman’s Rubner.
Thanks to a steady advance in equities this year, these rules-based funds have rushed to buy stocks, with positioning among volatility-targeting strategies hovering near a decade high.
Commodity trading advisers, or CTAs that surf the momentum of asset prices through long and short bets in the futures market, have loaded up so much stock that Rubner says even a small pullback would set off a violent unwinding. One number to watch, he says, is the S&P 500’s 50-day moving average. That trend line, currently near 4,438, hasn’t been breached since the banking crisis in March.
A dip below 4,278 could turn the medium-term momentum to negative for CTAs, his model shows. That level is near the index’s 100-day average.
“This is the theme here, if we start rolling downhill, there is an accelerant based on positioning and rules based trading,” Rubner wrote. “Volatility is a player on the field and no longer the coach.”
For much of 2023, US stocks have spent the time grinding higher with subdued volatility. Even after the recent increase, the Cboe Volatility Index, a gauge of cost in S&P 500 options known as VIX, hovers below its long-term average, poised for its calmest year since 2019.
A further pickup in volatility could ignite a rush for risk-off, just as it happened during the banking turmoil in March, according to Bob Elliott, chief investment officer at Unlimited. Many investors came into the year defensively positioned only to find themselves getting dragged into a resilient market.
“A big part of what has driven the rally, particularly in stocks, is low volatility in aggregate has led to people willing to take on more risk in the system,” Elliott said. “But if we transition to a period where there is more volatility, as we’ve seen in the last few weeks, that’s likely to constrain the leverage that investors are willing to apply to their positions and cause a drag on asset prices and eventually the economy.”
–With assistance from Isabelle Lee.
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