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Heavy options activity is amplifying investors’ frenzied retreat this week from bets on stronger economic growth.
The Dow Jones Industrial Average lost 3.4% for the week, its biggest drop in more than seven months. The S&P 500 fell 1.3% on Friday, ending its worst week since February. Timber prices are down 15% this week and have almost halved their highs in May. Gold and copper recorded their biggest one-week percentage declines since March 2020.
Stock market volatility has coincided with a surge in options activity, with more than 116 million options contracts set to expire on Friday, according to Cboe Global Markets data, the second-highest level ever after Jan. 15, when more than 150 million contracts were set to expire. It was expiring.
The sell-off prompted comments from Federal Reserve officials that slightly boosted investor expectations about future interest rate increases. The Fed’s forecasts released on Wednesday indicated the possibility of two interest rate increases in 2023, and St. Louis Fed President James Bullard said Friday that the central bank could tighten policy as soon as next year.
Comments got it wrong in a market that has become so obsessed with the threat of inflation. Volatility surged after slipping throughout the spring, and the asset class that many investors bet on rose due to the biggest drop, US Treasuries. The 10-year yield fell to 1.441% Friday, down from about 1.58% last month, before settling at its lowest level since March.
“Interest rate movements are the result of the continued unwinding of ‘deflationary’ bets,” said Charlie McCleggot, a macroeconomic analyst at Nomura, referring to investments that benefit from a broad economic expansion, such as banking stocks, energy stocks and many commodities.
So-called value stocks such as banks and energy companies, which are major beneficiaries of the economic recovery, have fallen, with the KBW Nasdaq Bank index now down about 12% from its recent high.
Friday’s volatility coincided with a surge in options activity related to single stock options and indexes that expire simultaneously.
Many investors have turned to selling options on a bet that stocks will continue to rise and volatility will decrease, in what is known as short selling volatility. This led to the steady backlog of options that were due to expire on Friday and contributed to calm markets in recent weeks, traders said.
The S&P 500 has been trading within a narrow range for several weeks. Since the beginning of June, the index has risen or fallen by no more than 0.5% every day except for two days through Thursday.
Going short by selling options or through risky exchange-traded funds was a common trade before the pandemic-induced market crash, although it backfired as the bull market ended last year, dampening enthusiasm for the trade.
Many were tempted to try their hand again as the S&P 500 index hovered around a record high. Rishabh Bhandari, senior portfolio manager at Capstone Investment Advisors, estimates that roughly 40% to 50% of the short-volatility bets that dominated the market before the pandemic have recently returned.
Dealers said that this limited volatility in the markets ahead of Friday, is likely to exacerbate the stock market movement on Friday as a large portion of the options expire.
“Today’s work with triple magic creates some of those fireworks,” said John Sherry, global head of options at Northern Trust Capital Markets, referring to the simultaneous expiration of several different types of options.
Many investors have bet on higher yields and lower bond prices in recent weeks, said Zoe Ren, portfolio manager at Penn Mutual Asset Management. These investors may have to cover their positions by buying back Treasuries, resulting in lower yields.
“The most likely reason is positioning. The situation was too short,” Mr. Ren said, referring to excess bets that yields would rise. “When prices start to go up, there is tremendous pain.”
Write to Gunjan Banerji at [email protected] and Anna Hertenstein at [email protected]
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