In the stock market, everything is not quite what it seems.
Slowing inflation has boosted investor confidence in the economy this year and, combined with intense enthusiasm for artificial intelligence, has provided the backdrop for a recovery that has exceeded all expectations.
The S&P 500 index climbed about 15% in the first half of 2024, reaching a record high.
The gains have been remarkably consistent, with the index only once rising or falling by more than 2% in a single day. (It rose.) A widely watched measure of bets on greater volatility ahead is near its lowest level on record.
But a look beneath the surface reveals much deeper turbulence. Nvidia, for example, whose stock price rally helped it become America’s most valuable public company last week, is up more than 150% this year. The price has Stocks have also seen deep falls several times over the past six months, each time reducing their market value by billions of dollars.
More than 200 companies, or about 40% of stocks in the index, are at least 10% below their highest level of the year. Nearly 300 companies, or about 60% of the index, are more than 10% above their lowest level of the year. And each group includes 65 companies that actually swung in both directions.
Traders say this lack of correlated movements – known as dispersion – between individual stocks is reaching historic extremes, undermining the idea that markets have been enveloped by tranquility.
An index from exchange operator Cboe Global Markets shows that dispersion has widened after the coronavirus pandemic, with technology stocks soaring while shares of other companies suffered. It has remained elevated, in part because of the stunning appreciation of a few select stocks at the forefront of AI, analysts say.
This presents an opportunity for Wall Street as investment funds and trading desks engage in dispersion trading, a strategy that typically uses derivatives to bet that index volatility will remain low while market turmoil individual stocks will remain elevated.
“It’s everywhere,” said Stephen Crewe, a longtime dispersion trader and partner at Fulcrum Asset Management. He believes the momentum has outpaced even the most anticipated economic data in terms of its importance to financial markets. “Right now, GDP or inflation data are pretty much irrelevant,” he added.
The risk for investors is that stocks could start moving in the same direction again, all at once, possibly because of a spark that triggers widespread selling. Some worry that when that happens, the role of complex trading on volatility could reverse and, rather than dampen the appearance of turbulence, exacerbate it.
The business of dispersal.
It is difficult to estimate the total size of this type of trading, even for those integrated into the market, in part because there are multiple ways to make such a bet. Even in its most basic form, scatter trading can include several different financial products that are also bought and sold for many other reasons.
How big is it? “That’s a million-dollar question,” Mr Crewe said.
But there are some clues. The options market has exploded – the number of contracts traded is expected to exceed 12 billion this year, according to Cboe, up from 7.5 billion in 2020 – and while there have always been specialists with shaky derivative strategies, it is now said that more and more traditional fund managers are piling in.
According to Morningstar Direct, assets of mutual funds and exchange-traded funds that trade options, including dispersion trading, have reached more than $80 billion this year, up from about $20 billion at the end of 2019. And bankers who offer their clients a way to replicate sophisticated transactions, but without the specialist knowledge, say they have seen a surge in interest in transaction dispersion.
But while its scale cannot be fully known, this perceived influx of funds has sparked comparisons to the last time volatility trading became popular, in the years before 2018.
At the time, investors flocked to options and leveraged exchange-traded products, which offered high returns in weak markets but were highly susceptible to selloffs that increased volatility. These trades were explicitly “short volatility,” meaning they profited when volatility fell but suffered big losses when the market turned turbulent.
So when calm suddenly returned to the markets and the S&P 500 fell 4.1% in one day in February 2018, some funds were wiped out.
While this dynamic persists, analysts say it is much less significant and that the advent of popular dispersion strategies is fundamentally different.
Since the trade seeks to profit from the difference between low index volatility and large swings in individual stocks, even in the event of a sell-off, the outcome is typically more balanced, with one side likely to increase in value while the other declines.
But even this generalization depends on how the transaction was executed, and certain circumstances could still cause problems for investors. This potential outcome partly explains why dispersion trading is getting so much attention right now: everything could go well, but it’s very difficult to be sure, and what if it doesn’t?
“Firewood is very, very dry,” said Matt Smith, a fund manager at Ruffer, a London-based asset manager. “And there’s a lot going on in the world, so it’s hot. »
The outcome could be ugly.
It is important to note that the largest companies in the market are also dispersed. Microsoft, which benefits from the enthusiasm around AI, has grown 20% this year. Tesla fell 20%. Nvidia remains the exception, with staggering gains.
So even on a day like Monday, when Nvidia fell 6.7 percent, the S&P 500 fell just 0.3 percent. The broad index was buoyed by other stocks, particularly other giant tech companies like Microsoft and Alphabet.
Calm seems to reign, despite the sharp drop in one of the most important components of the index.
When the really big stocks all start falling in concert, as they did in 2022, the result could be painful. Scatter trading could make the situation worse.
If S&P 500 volatility is pushed higher by a stock like Nvidia’s decline, but the damage is limited to the tech or AI sectors, an asymmetric outcome would hurt many spread trades, industry insiders say. Losses could spiral as traders looking to cut losses make trades that exacerbate volatility.
This possibility is hypothetical. Nvidia has yet to satisfy demand for its chips and its profits continue to soar. The dispersion could continue for some time given these unusual market dynamics, bankers and traders said.
But for some specialist investors more experienced with the complexities of trade dispersion, trading has lost its luster as it has been pushed to ever more extreme levels.
Naren Karanam, one of the market’s largest dispersion traders who operates at hedge fund Millennium Management, has scaled back his activity, seeing fewer profit opportunities, people with knowledge of his decision said. A rival hedge fund, Citadel, lost its top dispersion trader in January and opted not to replace him.
Even those remaining in the market say the current extreme dynamics, with volatility so low at the index level and dispersion among individual stocks so high, leave them with little appetite to increase their trades. Others have started to take the opposite side of the market, protecting themselves against a tumultuous selloff.
“Dispersion can’t go much higher and volatility can’t go much lower,” said Henry Schwartz, global head of client engagement at Cboe. “There’s a limit.”
