In the stock market, not everything is what it seems.
A slowdown in inflation has boosted investor confidence in the economy this year and, combined with an intense fervor for artificial intelligence, has provided the backdrop for a rebound that has exceeded all expectations.
The S&P 500 is up 15 percent in the first half of 2024.
Gains have been remarkably consistent, with the index only once rising or falling more than 2 percent in a single day. (It rose.) A widely followed measure of bets on higher volatility ahead is near its lowest level ever recorded.
But a look beneath the surface reveals far greater turbulence. Nvidia, for example, whose surge in share price helped it become the most valuable public company in the United States last week, is up more than 150 percent this year. It has also suffered repeated deep declines over the past six months, losing billions of dollars in market value each time.
More than 200 companies, or about 40 percent of the stocks in the index, are at least 10 percent below their high level this year. Nearly 300 companies, or about 60 percent of the index, are more than 10 percent above their yearly low. And each group includes 65 companies that have actually pivoted both ways.
Traders say this lack of correlated movement — known as dispersion — among individual stocks is at historic extremes, undermining the idea that markets have been surrounded by tranquility.
One gauge of this, an index from stockbroker Cboe Global Markets, shows that dispersion increased after the coronavirus pandemic, as technology stocks soared while shares of other companies suffered. It has remained high, in part because of the astonishing appreciation of a select few stocks in the artificial intelligence sector, analysts say.
This presents an opportunity for Wall Street, as mutual funds and trading desks pile into spread trading, a strategy that typically uses derivatives to bet that index volatility will stay low while turbulence in individual stocks remains high.
“It’s everywhere,” said Stephen Crewe, a veteran spread trader and partner at Fulcrum Asset Management. He believes these dynamics have overtaken even the most anticipated economic data in terms of their importance to financial markets. “It almost doesn’t matter what GDP or inflation data is right now,” he added.
The risk for investors is that stocks start moving in the same direction again, all at once, most likely due to a spark that ignites widespread selling. When that happens, some fear that the role of complex volatility operations could reverse and, rather than dampening the appearance of turbulence, exacerbate it.
Scattering trade.
Calculating the total size of such trades is a challenge even for those who are immersed in the market, in part because there are multiple ways to place such a bet. Even at its most basic, spread trades can involve several different financial products that are bought and sold for multiple other reasons as well.
How big is it? “That’s a million-dollar question,” 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 unconventional derivatives strategies, it is now He says more traditional fund managers are coming into play.
According to Morningstar Direct, assets in mutual funds and exchange-traded funds that trade options, including spread trading, have risen to more than $80 billion this year, from about $20 billion at the end of 2019. And bankers who offer clients a way to replicate sophisticated trades, but without the specialized knowledge, say they have seen a surge of interest in spread trading.
But while its full extent cannot be known, this perceived influx of funds has drawn comparisons to the last time volatility trading became popular, in the years leading up to 2018.
Back then, investors had piled into exchange-traded options and leveraged products that offered high returns in calm markets but were highly susceptible to sharp sell-offs that increased volatility. These trades were explicitly “volatility shorts,” meaning they profited when volatility fell but lost big when the market became turbulent.
So when calm suddenly broke out in the markets and the S&P 500 fell 4.1 percent in one day in February 2018, some funds disappeared.
While that dynamic persists, analysts say it is much less significant and the emergence of popular dispersal strategies is fundamentally different.
Because trading seeks to profit from the difference between low index volatility and considerable swings in individual stocks, even in a violent sell-off the outcome is usually more balanced, with one side likely to rise in value while the other decreases.
But even this generalization depends on how the trade was executed, and there are circumstances that could still cause problems for investors. That potential outcome is part of the reason why spread trades are getting so much attention right now: everything could be fine, but it’s very hard to know for sure, and what if it isn’t?
“The wood 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.”
Relaxation could be ugly.
The most important thing is that the largest companies in the market are also dispersed. Microsoft, a beneficiary of the AI enthusiasm, is up 20 percent this year. Tesla is down 20 percent. Nvidia remains the outlier, with staggering profits.
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 supported by other stocks, especially other giant tech companies like Microsoft and Alphabet.
Calm seemed to prevail, despite the sharp drop in one of the largest components of the index.
When all the very large stocks start to fall in unison, as they did in 2022, the result could be painful. Dispersion trading could make things worse.
If S&P 500 volatility is jolted higher by a stock like Nvidia falling, but the damage is limited to specific sectors in technology or artificial intelligence, a lopsided outcome would punish many dispersion trades, industry experts say. Losses could spiral as traders looking to cut their losses make trades that exacerbate volatility.
This possibility is hypothetical. Nvidia has yet to meet demand for its chips and its profits continue to skyrocket. The dispersion could continue for some time given these unusual market dynamics, bankers and traders said.
But for some more experienced, niche investors with the intricacies of spread trading, trading has lost its luster as it has been taken to ever more extreme levels.
Naren Karanam, one of the market’s top spread traders at hedge fund Millennium Partners, has scaled back his activity as he sees fewer opportunities to profit, people familiar with his decision said. A rival hedge fund, Citadel, lost its top spread trader in January and opted not to replace him.
Even some of those who remain in the market say that the current extreme momentum, with index-level volatility so low and individual stock dispersion so high, leaves them with little appetite to increase their trading. Others have begun to take the opposite side of the business, protecting themselves against a tumultuous sale.
“Dispersion can’t go up much and volatility can’t go down much,” said Henry Schwartz, global head of client engagement at Cboe. “There is a limit.”