Well-known funds that offer income-producing options may be reducing the current spike in volatility in US stocks, continuing the calming influence they have been exerting on the market over the past few months.
According to Morningstar data, assets under derivative income exchange-traded funds (ETFs)—funds that generate income by combining stocks and stock derivatives—have increased from $33 billion at the end of 2022 to approximately $71 billion.
Options experts think that the stock market’s wild swings have been subdued by these funds and other options-selling techniques, which is another factor contributing to the equity markets’ extended calm. A new tab is opened by the Cboe Volatility Index, or.VIX. Due to good results and prospects of rate reduction this year, Wall Street’s “fear gauge” dropped to its lowest point in two months in late March, sending equities higher.
The VIX has increased to hover around a seven-week high of 16.92 reached on Friday due to growing concerns that the Federal Reserve may not lower rates as much as anticipated in the absence of an inflationary resurgence. This suggests that the transactions may also have reduced recent volatility.
Despite being close to record highs, the S&P 500 had two days in a row of 1% swings last week—the first such movement in about two months.
The existence of funds dedicated to selling volatility was one moderating effect, but there were other factors that might have prevented volatility from rising much further.
According to Alex Kosoglyadov, managing director of equity derivatives at Nomura, the existence of funds that sell volatility was one moderating influence, even if a number of variables might have prevented volatility from rising even further.
“There’s been tremendous growth in these ETFs, QIS (Quantitative Investment Strategies) and in mutual fund strategies that have been selling options for income,” said Kosoglyadov. “We see it every day. It definitely has a pronounced impact on the market.”
There is an extremely slim chance that rates will rise significantly from where they are currently.
There are many different types of options selling strategies, such as those that sell calls, puts, or a mix of these, with or without stock ownership. It is challenging to determine the precise market impact they might have at any particular time due to their diversity. Together, nevertheless, they lessen fluctuations in the market.
Selling out-of-the-money call options, or contracts with strike prices far higher than where the market may be trading, against their stock holdings is one way that certain options sellers of exchange-traded funds (ETFs) make money.
Selling stock index futures allows market makers, or institutional players like large banks, who are taking the opposite side of these trades, to reduce their exposure to the bullish contracts. The ETFs are compelled to buy back the call options they sold as markets grind higher, as they have been doing recently. This forces market makers to close their own hedges by purchasing index futures, which support stocks.
Kris Sidial, co-chief investment officer of volatility arbitrage fund Ambrus Group, said, “That’s one of the reasons you have seen volatility so low over the last few years.”
As volatility has increased, there has been a “massive wave of supply of index volatility,” according to Sidial.
According to UBS equity derivatives analyst Maxwell Grinacoff, while these options-selling techniques help moderate market movements in the background, they probably wouldn’t stop a selloff in the event that the outlook for stocks drastically changed.
On Wednesday, the United States will release consumer price data for March, which might be a flashpoint.
An unexpectedly high number may heighten concerns about inflation and weaken the case for interest rate reductions, which have been a major factor in the bull market that has raised the S&P 500 by almost 26% from its October 2023 lows.
On Wall Street, the short-volatility strategy has a mixed history. Known as “Volmageddon,” a volatility-tracking note named the VelocityShare Daily Inverse VIX Short-Term ETN crashed in February 2018, wiping out about $2 billion in investor assets.
Grinacoff and more choices Because the newest generation of options-selling funds is structured differently and is less concentrated in its posture than previous funds, market players are dubious that they represent the same kind of systemic risk.
However, several market players are concerned about potential outcomes in the event that these techniques are abruptly undone.
According to Ed Clissold, chief U.S. strategist at Ned Davis Research, “When volatility increases, and you’re dealing with derivatives, it’s always difficult to know what will be impacted when.”