For two decades, Amy Wu Silverman has tracked fear and greed across Wall Street by keeping a close eye on the twists and turns in the Cboe Volatility Index.
(Bloomberg) — For two decades, Amy Wu Silverman has tracked fear and greed across Wall Street by keeping a close eye on the twists and turns in the Cboe Volatility Index.
But last year, she spotted something odd: As stocks plunged in the great inflation crisis, the gauge known as the VIX — which reflects how options traders are betting on swings in the S&P 500 — barely budged. In recent weeks, things have got stranger still.
As the Treasury market rout intensified, equities plunged more than they did during the regional bank turmoil in March. Yet the volatility index has still sat below the widely watched level of 20. That’s even as a surprise conflict grips the Middle East and economic worries build on soaring borrowing costs.
It’s the first time since 2012 that the Cboe benchmark has stayed this low during stock drawdowns of 5% or more, according to data compiled by eToro and Bloomberg.
In searching for reasons, Silverman, who heads up derivatives strategy at RBC Capital Markets, points to the trading frenzy in ultra-short dated options and a marketplace ever more divided between stock winners and losers.
But another less noticed but fast-growing force, she says, is the boom in options-selling strategies this year that are sucking in billions of dollars like never before. In previous years, similar trading activity in derivatives-powered investment funds was also blamed for muting the VIX as a signal on economic and market angst.
“If you remember 2017, right before we got into Volmageddon in February 2018, the volatility environment smelled similar to right now,” Silverman said.
Derivatives specialists at firms including Morgan Stanley and Nomura Securities International have also argued that options-selling funds are acting as a market tranquilizer, day in day out. That’s because whenever the cost of options, or implied volatility in derivatives parlance, creeps up, money managers are ready to jump in and write contracts in order to generate income — all of which essentially serve as indirect wagers on stock calm.
In one view, the lack of reaction in the volatility market can be framed as a sign that traders are sanguine about the market outlook, fueled by the projected recovery in corporate earnings and historically favorable equity patterns in the fourth quarter.
Yet, the newfound boom in the vol-selling trade has played a key and under-appreciated role, according to a cohort of institutional pros. The VIX peaked at 19.78 as the S&P 500 dropped almost 8% from its July high through last Tuesday. Back in March, when stocks put on a similar retreat, the volatility measure spiked above 26.
Underpinning the options-selling strategies is investor desire for steady income that’s only growing at a time when the Fed’s battle against inflation makes both stock and bond returns potentially less reliable.
The popularity of the trade is evident in the world of exchange-traded funds, where BlackRock Inc. just joined a flurry of firms to launch products that write calls as part of a stock portfolio. With mundane monikers like buy write, covered calls and put write, ETFs employing the options-selling strategy have seen their assets jump 70% this year to a record $59 billion, according to data compiled by Global X ETFs.
Buy-write funds that purchase stocks and simultaneously sell call options on these shares have seen at least 10 new launches this year, data compiled by Bloomberg shows.
These funds “have proliferated like wild fire around the Street,” said Charlie McElligott, Nomura’s cross-asset strategist. “All nascent vol bids get smashed by index and single-name options sellers generating income from premium.”
One signature feature of 2023 trading is a violent stock rotation underneath the market calm. Tech companies, last year’s biggest laggards, have jumped to the top of the leaderboard, while old winners like utilities are at the bottom. The gap between the best- and worst-performing industries is 63 percentage points, the third widest this far into a year since 2000.
This trading dynamic has emboldened another popular options trade that’s designed to exploit the volatility discrepancy between broad indexes and their underlying constituents. In the current environment, the so-called dispersion trade often comes in the form of shorting index vol against single-stock vol — a dynamic that feeds into the broad market tranquility, according to McElligott.
Of course, volatility selling is not the only force at play. Many participants point to a yearlong trading explosion in options that mature in 24 hours as another potential reason for the VIX’s muted movement in a market ridden with threats such as a hawkish Fed and an economic recession.
The thinking goes that traders are flocking to contracts with zero days to expire, or 0DTE, to navigate intraday volatility, especially when Fed meetings or inflation data are expected to spur market swoons. While all the rush reflects heightened anxiety in the marketplace, none of that is captured by the VIX, which is calculated based on only S&P 500 options expiring about one month into the future.
Whatever the reason, the battle is intensifying on whether the market will stay calm or not after a year of double-digit equity gains fueled by artificial intelligence euphoria and the resilience of the US economy. Trading volume on VIX options, with calls betting on turbulence while puts wager on peace, has jumped to 746,000 contracts a day this year — poised for an annual record.
Notably, last time when VIX option transactions were this busy in 2017, it happened in a year when short volatility — a bet that equity markets will stay calm — was all the rage. That didn’t end well. The following February saw a collapse in a spate of exchange-traded notes designed to move in the opposition direction to the VIX, when the latter spiked.
The current rush of options selling is mostly intended as a way to generate income streams, rather than a direct wager on equity peace. It also comes with limited leverage. Still, it’s one breed of the short-volatility trade that has historically provided investors with gains — but can fall prey to big drawdowns.
“It works until it doesn’t,” RBC’s Silverman said.
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