(Bloomberg) — Deep at the heart of the options world lies a threat to the stock market’s year-long calm.
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While the benchmarks just slumped in one of the smallest weekly changes of 2023, the intraday moves tell a different story. The upward and downward fluctuations in the S&P 500 are the widest since June and double what they were in the past month. Twice in the past six sessions, index futures have erased gains of 0.9%, the first time this has happened since February.
While uncertainty about the economy and central bank policy has been one of the triggers, something else may be contributing to the volatility: market makers are repositioning their exposures. There is evidence that these Wall Street traders – who have the ability to move millions of shares to hedge their books – have shifted into a situation where selling them has the potential to exacerbate market volatility.
Any temporary turmoil and betting on price swings is likely to be a popular trade. But this change in dealer status is a departure from the first seven months of the year when the group played a major role in reducing price volatility, according to a model maintained by Scott Rubner, managing director of Goldman Sachs Group Inc.
“Market movements are intensifying, and they are no longer muted,” Rubner, who has studied money flows over two decades, wrote in a note Thursday. “This is new.”
Stocks fell for a second week as a mixed batch of inflation data added to an already raging debate over whether the Federal Reserve is done raising interest rates and for how long the economy can avoid a recession. The S&P 500 fell 0.3%, while the Nasdaq 100 ended a two-week decline down 4.6%.
For the five sessions through Thursday, the S&P 500 posted an average intraday swing of 1.1% — the widest turnover since June, according to data compiled by Bloomberg. While the volatility pales in comparison to the bear market of 2022, it is nearly double the average daily move from just two weeks ago.
“There is still potential for a soft landing and there is still potential for a consumer dip, which leads to a contraction in the company’s earnings,” said Tom Heinlein, national investment strategist at US Bank Wealth Management. “People trade on two ranges of outcomes, so you just have that push and pull.”
A potential accelerating factor in the process is recognized by the concept known in derivatives parlance as gamma, or the theoretical value of shares that options traders must buy or sell to hedge against directional risk arising from price changes in the underlying asset.
Getting a clear read on the interaction between the vast world of derivatives and the underlying stocks is certainly not easy. Often, models based on subjective assumptions formulate different figures on how much hedging is required of a market maker in a given scenario. Although this analysis is not an exact science, it does provide a lens into the potential impact of the complex world of derivatives on the money market.
And now, two widely-watched Wall Street trading desks are sounding alarms about potential turmoil on the horizon as options traders move away from their “long gamma” positions — a situation that previously forced them to reverse the prevailing market trend, sell stocks when they rallied, or vice versa.
According to Goldman’s model, the group’s exposure to S&P 500 options this week turned negative for the first time this year, while for all index contracts it was the shortest since last October.
The shift was also caught by the Morgan Stanley team led by Christopher Metley, who reported a drop in traders’ exposure of more than 80% a few weeks ago. The team noted that the decline coincided with a slowdown in volatile selling — the type of activity increasingly driven by exchange-traded funds that sell long contracts for income.
That, combined with the current activity of leveraged ETFs — those that use derivatives to generate many times the performance of the underlying asset — means the market is vulnerable to larger moves, according to the Morgan Stanley team.
“He will sell The Street at the bottom bar and buy it at the upper bar,” they wrote. “This is likely to be temporary – but for now it leaves the market free to move.”
There are signs that traders are reluctant to bid on the shares 10 months later, as a 28% rally has pushed the S&P 500’s price-to-earnings ratio to highs it has only reached twice in the past three decades. Funds focused on US stocks just saw their first influx in three weeks, according to Bank of America Corp., citing data from EPFR Global.
The S&P 500 fell nearly 3% in August, and is on track to its worst start in a month since March. The downturn, if it continues, could trigger a mass exit from regular money managers who allocate assets based on volatility and momentum signals, according to Goldman’s Rubner.
Thanks to the steady advance in equities this year, these rule-based funds have scrambled to buy stocks, with them among their strategies targeting volatility hovering near a decade high.
Commodity trading advisors, or CTAs that sift through asset price momentum through long and short bets in the futures market, have loaded so much stock that Roebner says even a small pullback would lead to a violent breakup. One number to watch, he says, is the S&P 500’s 50-day moving average. This trend line, currently near 4438, has not been broken since the March banking crisis.
His model shows that a drop below 4278 could turn medium term momentum into negative for CTAs. This level is close to the 100-day average of the index.
“That’s the point here,” Rubner writes, “if we start rolling downhill, there’s acceleration based on positioning and rules-based trading.” “Flip is a player on the field and no longer a coach.”
For much of 2023, US stocks have spent the time rallying with subdued volatility. Even after the recent increase, the Cboe’s volatility index, a measure of the cost of options in the S&P 500 otherwise known as the VIX, is hovering below its long-term average, and is poised for its calmest year since 2019.
A further spike in volatility could trigger a rush to move away from risk, just as it did during the banking turmoil in March, according to Bob Elliott, chief investment officer at Unlimited. Many investors came into the year on the defensive only to find themselves drawn into a resilient market.
“A big part of what drove the rally, particularly in equities, was lower volatility overall, which has resulted in people being willing to take more risks in the system,” Elliott said. “But if we move into a period where there is more volatility, as we’ve seen in the last few weeks, that could potentially limit the leverage that investors are willing to apply to their positions and cause pressure on asset prices and ultimately the economy.”
– With help from Isabel Lee.
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