© Stocksak. FILE PHOTO A specialist trader works on New York Stock Exchange (NYSE), New York City, U.S.A, October 17, 2022. REUTERS/Brendan McDermid
Carolina Mandl and Saqib Ahmed Iqbal Ahmed
NEW YORK, Stocksak – The recent surprise success of bulls as well as bears in the U.S. equity markets has been attributed to a surge in short-term options betting, rock-bottom equity allocations, and tandem moves in individual stocks.
The index’s one-month volatility, which measures how much the index moved in the past month, has reached its highest point since July. This year, the index has seen 40 moves in either direction of more than 2%. This is a record that was only possible during the heights of the pandemic in 2020 and the depths of 2008-2009’s financial crisis.
Friday’s latest rally was triggered by fresh hopes that the Federal Reserve would reduce its monetary policy tightening. The S&P 500 gained more than 2% for the day, after being down as much as 0.5% earlier in the session.
“We are seeing large movements not just to the downside… but surges towards the upside as investors seem to be chasing returns through the year-end,” stated Anand Omprakash of Elevation Securities, head of the derivatives quantitative strategy.
GRAPHIC: Big swings https://graphics.reuters.com/USA-STOCKS/gkplwmgdgvb/chart.png
The swings are fueled by a flood of options trades. Many of these options trades are short-term. According to Trade Alert data, the average daily trading volume for the U.S.-listed equity options market is 43 million contracts per month, which is just shy of a record and 20% more than a year ago.
A surge in options trading tends to boost hedging by market makers – typically large banks or financial institutions that facilitate the trades and need to position in equity futures to reduce their risk from unexpected market moves.
According to market participants, their furious buying or selling can increase volatility and short-term swings of stocks.
Garrett DeSimone, head quantitative research at OptionMetrics, stated that “Dealer hedging on derivatives markets has absolutely been a factor influencing market movement over short term horizons.”
He said, “I expect these hedge flows to likely exert most influence during low liquidity times, and following significant macro news events.”
GRAPHIC: Options surge https://graphics.reuters.com/USA-STOCKS/jnpwygyqdpw/chart.png
Market participants claimed that a rise in trading options contracts expiring in less than one day further exacerbates swings. Because they are close to the expiration date, they are particularly sensitive to stock volatility and require increased hedging.
Trading in S&P 500 options with one day or less to expiry has grown to be 50%-60% of the volume, up from 10%-30% earlier this year, according to Kochuba, founder of analytic service SpotGamma.
Kochuba stated, “I believe this invokes a ‘jumprisk’ in markets…hidden pockets of volatility which are very difficult to forecast.”
Many “real money” investors, such as mutual funds and pension funds, have reduced their stock allocations after months of equity volatility. This is another factor that fuels stock swings.
“The recent volatility is… due to’real money’ sitting on their hands, and not being available to either buy into weakness or sell into rallies,” stated Michael Lewis, head U.S. equities Cash trading at Barclays (LON:).
Deutsche Bank (ETR:),’s measure of consolidated stock positioning has been lower than 6% of the times since January 2010. Data from Goldman Sachs’ (NYSE:) prime brokerage revealed that the week of Oct 7th, net leverage in hedge fund portfolios was at its lowest point since March 2020.
Market participants stated that under-positioned investors have been jumping on stock rallies recently, further extending the moves.
“Some investors are looking for very short-term tactical bear markets rallies while more medium-to long-term conviction remains very bearish,” stated Maxwell Grinacoff (OTC:), equity derivative strategist at BNP Paribas.
MARCHING IN A LOCKSTEP
The abruptness of the movements has been aided by a rise in correlations between individual stocks. The Cboe 3-Month Implied Correlation Index, which measures the 3-month expected average correlation across the top 50 value-weighted S&P 500 stocks, stands at 53.53, near a 2-year high, and 18 points above its 5-year median.
GRAPHIC: In lockstep https://fingfx.thomsonreuters.com/gfx/mkt/gkvlwmxmapb/Pasted%20image%201666627273301.png
Stocks that move in the same direction as each other on the same catalysts have a lower chance of one stock moving against another. Higher correlation can cause the market to move with increased speed.
Elevation’s Omprakash stated, “It has become a macromarket in which individual catalysts don’t matter as much”