17 hours ago
Traders wrestle with stocks' muted reaction
NEW YORK: The stock market's recent calm in the face of rising geopolitical threats had left options traders with a conundrum: sell volatility and risk being blindsided should the Middle East conflict escalate, or buy it and bleed away premiums as actual moves stay subdued.
That tension is set to ratchet even higher after the United States attacked Iranian nuclear sites.
While the oil market is still likely to have the biggest reaction to the escalating conflict, equities may see an initial jump in volatility as traders try to digest the risks.
Oil has surged 11% since Israel launched airstrikes on Iran a little more than a week ago, with crude volatility soaring to levels not seen since Russia's invasion of Ukraine in 2022. By contrast, the S&P 500 Index is down just 1.3%.
'Markets will react, but probably still modestly in equity markets,' said Anthi Tsouvali, a strategist at UBS Global Wealth Management.
'Investors will also have to think about the impact of higher oil on inflation.'
Some traders may be growing numb to Donald Trump's flip-flops, or just tired of chasing the headlines.
In six months, markets have gone from 'Buy America' to 'Sell America' to now something murkier.
They've learned to snap back quickly whenever risks subside, and that could happen again with the latest oil spike, which threatens to keep US inflation higher and slow Federal Reserve rate cuts.
It's a dilemma facing volatility traders like Gareth Ryan, the founder and managing director of investment firm IUR Capital.
'Selling volatility at current levels inherently carries the risk of a volatility event, but paying out premiums with the expectation of a spike higher in vol also means holding a wasting asset,' Ryan said last week.
For the options market, this environment has led to a muddied picture. On the one hand, implied volatility has dropped significantly from a high two months ago.
But on the other, premiums aren't cheap. The collapse of realised swings on major equity gauges is making them look expensive.
As of last Friday, the Cboe Volatility Index was near its highest level since April relative to actual S&P 500 volatility.
The trend was similar for European stocks and Chinese equities traded in Hong Kong.
While the options market was underpricing moves ahead of Liberation Day, making some volatility structures very profitable during the 'gamma shock' it triggered, the environment is different now that headline risk has a smaller impact.
As the July 9 tariff deadline approaches, some strategists are saying a long gamma positioning is unlikely to yield the kind of bumper profits seen in April.
'On the more tactical side there is a general lack of scalable opportunities across the board on repo, correlation and volatility – historic dislocations are just not there at the moment,' Antoine Porcheret, head of institutional structuring for the United Kingdom, Europe, Middle East and Africa at Citigroup Inc, said last week.
'But that is part of a deeper long-term trend, notably in retail structured products, which historically was the main supplier of derivatives risks.'
JPMorgan Chase & Co strategists, who noted on June 11 that investors' fatigue has set in after the many Trump U-turns, said the July 9 deadline could be postponed, which would create further uncertainty and make it difficult to trade with conviction.
Dealing has already shifted to near-term maturities.
S&P 500 options volume has dropped since May, with the share of zero-days to expiry contracts reaching a new peak of 59%, a separate JPMorgan report showed last week.
One sign that there is a bit more concern among equity traders: The Cboe VVIX Index, measuring the volatility of the VIX, has increased to the higher end of its range over the past year, signalling more interest in buying options for portfolio protection against drastic swings.
The conflict, and the muted reaction in stocks, has driven implied volatility for the US Oil Fund relative to the SPDR S&P 500 ETF to the highest level since the early days of Covid in 2020.
That's led banks to pitch more dual-binary hybrid trades between oil and equities.
'In such geopolitical and macro environments, hybrids have been a natural tool to use, with recent activity around the oil theme played versus equities, and foreign exchange, through directional and volatility trades,' said Alexandre Isaaz, head of Europe, Middle East, and Africa equities derivatives sales and structuring at Bank of America Corp.
To reduce risk while keeping their views, some buy-side investors are using strategies such as stock replacement – when an equity position is put on with options instead.
One trader alone spent as much as US$3bil in premium on 2027 calls across a slew of large-cap US companies in recent months.
'I don't sense much fatigue from hedge funds, they are still actively looking for opportunities. On the vol carry side within the QIS (Quantitative Investment Strategies) space there is still demand,' said Porcheret.
'The market is generally underinvested, so the pain trade remains to the upside.' — Bloomberg
