Broad measures of equity implied volatility (the options market's anticipation of future stock movement) decline, hinting at reduced concerns about the economy and valuations. The shift follows a period of stocks and their implied volatility consistently rising together. We unpack why all this is herein, starting with where we were.
In recent months, a frenzy propelled large stocks higher. Among the favored tactics, institutions and retail investors bought call option contracts, a cost-effective means to hedge bets against equities or partake in potential upside. This phenomenon indirectly amplifies market thrusts, primarily through the hedging process, where a customer purchases a call option, and the counterparty sells it while dynamically hedging with purchases of the underlying stock. This mechanism partly contributed to the rapid ascent of weighty index constituents like Nvidia Corporation (NASDAQ: NVDA). However, as enthusiasm wanes (resulting in cheaper options due to decreased demand or increasing supply), it can set the stage for contrasting outcomes and vulnerability in the overall market.
Have no fear, though. As the broadening breadth shows, the less weighty constituents save the day. Such a rotation and momentum seldom precede immediate crashes and instability. Historically, rallies persist, resulting in double-digit returns for investors a year later. After all, it is an election year with fiscal spending and deglobalization counteracting contractionary monetary policy or the notion of it (i.e., rising money deployed in growth and monetary inflation hedges).
The key observation is that generating profits from high-performing stocks is more challenging. Gone are the times of chasing upward movements, where the potential gains far outweighed the risks. Implied volatility in stagnant stocks like Super Micro Computer Inc (NASDAQ: SMCI) has dropped by over 100% for out-of-the-money call options with about a week to expiration. With the stock now an S&P 500 component, both realized and implied volatility may continue downward. Consequently, the strategies we’ve shared turn costly and are less profitable.
Like Ariana Grande says, “Thank u, next.”
If high-performing commodities like cocoa aren’t for you, so-called “digestion” trades (e.g., calendar spreads) or direct bets on equity volatility bursts may be. The first idea regards selling options and using those proceeds to buy similar options that expire later. The other is to hedge downside thrusts in equities via call options in the Cboe Volatility Index (INDEX: VIX), Goldman Sachs, and UBS note. The latter isn’t necessarily optimal. Savvy traders know low implied volatility can stay low (e.g., 2017). Cheap is cheap for a reason, and the market’s current position suggests lower odds of expansive movement; instead (and this isn’t advice), calendar and ratio spreads, a play on the current richness of out-of-the-money put options, stick out. We’d aim to use the proceeds of these portfolio volatility-reducing trades to cut our cost basis or buy more stocks. See this case study from 2022 for some context.
Now, in what case would those VIX trades perform? There would have to be enough downside follow-through to warrant an adjustment to the status quo and for people to demand protection and re-price cheap insurance big. Some say that figure sits at -5 or -10%, where the stabilizing forces from common options selling strategies fade, writes FT, “leaving markets more vulnerable to other selling flows (e.g., from volatility targeting funds, CTAs/momentum investors, short gamma flows from hedging puts and levered ETFs, discretionary investors).”
Upon further downside, previously indiscriminate options selling may come into focus as sparks for cascades, similar to February 2020’s historic reach for insurance to cover, protect, and fix margin issues. As a result of dispersion trades and other things, the VIX has fallen more relative to single-stock implied volatility, offering poor rewards for optimistic investors and newer yield-hungry volatility sellers. Investors hedging could be better off avoiding options altogether, allocating instead to the S&P 500 and T-bills or debt issued with short-term maturities.
Investing in T-bills can tie up a little margin. If your account allows, the remaining cash and margin can be used to buy stock or its synthetic equivalent (i.e., buy a call and sell a put) or construct asymmetric bets to the upside. For alternative trading ideas, please check out our “BOXXing For Beginners” newsletter, in which we discussed using portfolio margin, box spreads, and unbalanced call spread structures to capture the upside more efficiently.
Nevertheless, the current low implied volatility scenario suggests investors expect little upset. If their assumptions are wrong, it could portend significant repricing if or when things sour. The market reflects this with a multimodal reality/pattern as options further out are sticky, displaying heightened premiums. It's an expectation that minimal change or a significant event transpires—little middle ground.
Until next time, peace! ✌️