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A complicated derivatives trade that may have helped power some of the U.S. stock market’s post-March rally is showing signs of unwinding, with potential consequences for the broader market, one veteran analyst warned Tuesday.
Should it come completely unglued, the result could be nearly 500 points shaved off the S&P 500 index, a move that would erase much of this year’s nearly 18% gain, FactSet data show.
In his latest missive to subscribers, Michael Kramer, founder of Mott Capital Management and a longtime independent market analyst, said he’s seeing signs that a complicated play known as the “short volatility dispersion” trade is starting to unravel, threatening a rapid unwind, if the past is any guide.
Here’s how the trade works, according to Kramer: traders purchase call options on Big Seven stocks like Apple Inc.
AAPL,
while at the same time selling call options on the S&P 500
SPX
index to offset the cost of the individual stock options.
Then, they hedge their short position with shares in Apple or other S&P 500 components, helping to limit their risk should the trade move against them.
A call option gives traders the right, but not the obligation, to buy shares in a given stock, although index options are often settled in cash or in futures tied to the index.
Kramer has been tracking the trade in his newsletter for months. He believes sophisticated traders saw opportunity after the collapse of Silicon Valley Bank, when the Cboe Volatility Index, otherwise known as the Vix, traded as high as 30 intraday, its highest level of 2023.
Those who put this trade on hoped the S&P 500 would continue to rally, sending the Vix lower, while traders would continue to pile into call options on the Big Seven stocks. In a way, the trade is also a bet that individual S&P 500 components would outperform the index, which has been a major theme for markets this year.
Heading into the second-quarter earnings reporting season, the trade worked well as the Vix fell while the so-called “Magnificent Seven” stocks pushed the S&P 500 higher.
This group includes Apple Inc.
AAPL,
Microsoft Corp.
MSFT,
Alphabet Inc.’s Class A
GOOGL,
and Class C
GOOG,
shares, Meta Platforms Inc.
META,
Amazon.com Inc.
AMZN,
Tesla Inc.
TSLA,
Nvidia Corp.
NVDA,
For months, the Vix continued to fall, cheapening the price of S&P 500 index options, while heavy demand for options tied to the market leaders drove implied volatility on those individual stocks higher, creating the volatility-dispersion effect from which the trade derives its name.
To see whether the trade is working, traders could monitor the Cboe’s one-month implied correlation index, which measures the difference between implied volatility for the S&P 500 and individual stocks in the index.
CBOE
The trade is working so long as the line in the chart above is declining.
But after falling to its lowest level since early 2018 in late July, dispersion suddenly lessened over the past week as stocks like Apple sank along with the broader market, sending the Vix back above 17 for the first time since late June, FactSet data show.
“The important thing to remember is this is just an implied volatility trade. What they’re trying to do is bet that volatility will mean revert, which means fall from where it had been,” Kramer told MarketWatch during a phone call.
“The person is selling index options and buying options on the index components. That’s a bet that the implied volatility of the S&P 500 is going to fall, and by buying calls on the underlying stocks, they’re hedging against long-volatility risks.”
Kramer believes that during its heyday, this trade helped to create a perpetual motion machine. Buying individual stocks and individual equity call options should push the S&P 500 up, and implied volatility on the index down, inspiring more traders to pile in, creating a cyclical effect that pushed stocks higher and printed profits, until it didn’t.
Now, Kramer sees risks that the trade could completely unwind.
Financial conditions have begun to tighten again as the U.S. dollar has strengthened while global bond yields have risen recently.
Tighter financial conditions are typically associated with higher implied volatility for stocks, as traders brace for blowback to equity valuations caused by more attractive yields on bonds, along with the possibility that the real economy might suffer as corporations’ borrowing costs rise.
“For this trade to be profitable, the implied volatility of the S&P 500 needs to be moving in the opposite direction as the implied volatility on the individual stocks,” Kramer said.
“If you start to see the Vix rise, that’s a bad sign, because it means that the trade is no longer working.”
While it’s not a perfect analogy, Kramer sees echoes of “volmageddon,” when the Vix doubled on Feb. 5, 2018 as a popular short-volatility trade unwound, lashing stocks in the process. On that day, the Dow Jones Industrial Average
DJIA
recorded what was then its biggest daily point drop on record.
It’s just another example of how activity in equity derivatives markets can drive trading in the underlying assets.
“If this trade continues to unwind, we could continue to see more downside in stocks,” Kramer added.
U.S. stocks were falling again on Tuesday, with the S&P 500 down 1.2% at 4,466, while the Vix shot up to 17.5, its highest level since May, FactSet data show.
The Nasdaq Composite
COMP,
which is more heavily weighted to the Magnificent Seven, fell even further, down 1.4% at 13,802.
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