The historic lull in the equity market has revived a controversial strategy of selling volatility. Though one calming factor is likely to fade as Friday’s options expiration risks creating fresh turmoil for traders.
(Bloomberg) — The historic lull in the equity market has revived a controversial strategy of selling volatility. Though one calming factor is likely to fade as Friday’s options expiration risks creating fresh turmoil for traders.
Big benchmark swings have been missing of late as defensively positioned investors digest conflicting economic news and the US debt ceiling drama from the sidelines. The S&P 500 has posted daily moves of less than 1% in all but six of the past 33 sessions.
Stuck in a 3.8% range since March, the benchmark index is on course for the calmest quarter since 1993. Thanks to that backdrop of peace, indexes tracking strategies of writing bullish and bearish options are notching their best stretches of weekly wins in at least one year.
That success will be challenged Friday as piles of options reach maturity. About $1.7 trillion of derivatives contracts tied to stocks and indexes are scheduled to expire, according to data compiled by Goldman Sachs Group Inc. strategist John Marshall.
The monthly event, known as OpEx, typically obliges traders to either roll over existing positions or start new ones. That usually involves portfolio adjustments that lead to a spike in trading volume and sudden price swings.
Contributing to the market’s current tight trading are market makers — who are on the other side of options transactions and need to buy or sell equities to keep a neutral position. These days, they have been mired in a state known as “long gamma,” a stance that requires them to go against the prevailing trend, buying stocks when they fall and selling when they rise.
The S&P 500’s overall gamma exposure from options dealers is expected to drop by almost 30% after Friday, according to Nomura Securities International estimates.
The release of long gamma trades “gives us a chance to break out,” said Nomura’s cross-asset strategist Charlie McElligott.
The S&P 500 climbed Thursday to the highest level since August. While surpassing its February high, it failed to hold above the widely watched level of 4,200.
While this options event opens the door for volatility, it doesn’t guarantee an end to the calm. A month ago, when the market was held back by a similar dormancy, expectations grew that OpEx could bring an end to the inaction. The S&P 500 posted two of the year’s biggest moves in the following week, only to settle back into a new stretch of stillness.
That’s because conflicting forces abound and they offset each other. While rules-based traders have piled into stocks, partly lured by the sense of quiet, human traders have kept their exposure low amid concern over everything from banking stress to a looming recession. Even in the options market itself, there has been a push and pull between zero-day bets and long-dated contracts.
The lack of big swings is emboldening the trade of shorting volatility. Whether it’s bullish calls or bearish puts, supply appears to be on the rise lately, according to a handful of options traders and specialists. That’s because when the market is stuck, out-of-money contracts often expire worthless, letting anyone who sold them pocket the premium.
The Cboe S&P 500 PutWrite Index (ticker PUT), which sells at-the-money bearish options on the benchmark against cash reserves, is on course for a 10th straight weekly gain, the longest stretch in a year. A similar gauge for calls, the Cboe S&P 500 BuyWrite Index (ticker BXM) has been on a similarly robust run.
Joseph Ferrara, an investment strategist at Gateway Investment Advisers, has seen increased client interest in the firm’s low-volatility products in recent months.
“Where we are today, slightly up to flat and slightly down, is almost an ideal situation for us,” he said.
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