Options Mania and Real-World Risk Mean Volatility Here to Stay

Job losses persist. The global economic recovery from Covid-19 remains tenuous. The U.S. presidential election is less than two months away, Congress seems unable to agree on additional stimulus and Brexit is once again facing roadblocks.

Any of those macroeconomic risks by themselves would be enough to make investors antsy. But add in the extremely active options market that’s taken hold in 2020, and stock buyers have reason to be concerned that a surge in volatility lies ahead.

The wild swings continued Thursday, when the tech-heavy Nasdaq 100 gave up a 1.5% rally to end down 2%, continuing a trend of outsize moves that have characterized trading this month. The index has moved more than 1% every day in September, the longest such streak since March, when stocks were nearing the end of their bear-market descent.

Now, with the gauge up near 60% from its low, froth in the options market, and plenty of ways for things to go wrong over the next few weeks, traders need to steel themselves, according to Yousef Abbasi, a global market strategist at StoneX.

“Investors probably are a bit nervous on the back of the last pullback we saw despite yesterday’s impressive rally, considering the approaching risks,” Abbasi said in an interview. “Some of which, like the election, are calendar driven and others of which are difficult to price like the threat of second wave as we enter autumn.”

Options Mania and Real-World Risk Mean Volatility Here to Stay

That unease was evident Thursday, as the Nasdaq 100, the focal point of the recent stock correction, staged a 0.7% intraday swing at least eight times.

The options market, which has drawn a lot of attention in recent weeks for potentially exacerbating the stock rally and correction -- particularly in large tech stocks -- remains extremely active.

Big bets on derivatives are likely to spur further market volatility, at least through the quarterly expiration at the end of September, according to Steve Sosnick, chief strategist at Interactive Brokers. Potentially adding to the turmoil is the Federal Reserve meeting set for the middle of next week.

“All those options mean that every time we cross a strike, someone needs to re-hedge,” Sosnick said. “Large open interest makes it more likely that we lurch back and forth.”

On Thursday, the most actively traded options included calls expiring Friday for Apple Inc., the largest S&P 500-tracking exchange-traded fund, and Tesla Inc. Total call volume for both Apple and Tesla was 30 times the average over the past 20 days.

Plenty of Froth

Measures of sentiment tracked at The Leuthold Group show that even after the three-day selloff in the stock market that began last week, there’s still plenty of froth in the market. Doug Ramsey, the firm’s chief investment officer and a skeptic of the historic equity rebound, pointed to a Cboe Equity Put/Call ratio still in “danger territory” as one example. The firm’s 10-year annualized projected total return for the S&P 500 also fell below 2% for the first time since July 2001 in the midst of the dot-com crash.

“While economic upturns usually inoculate the stock market against major declines, there’s at least one precedent in which a similarly overvalued stock market kept falling (led by the old Growth leaders) after the ‘recessionary’ phase of the bear market didn’t complete its job,” he wrote in a note to clients Wednesday.

But even if levered options plays have fueled stock market moves in recent months, that doesn’t necessarily mean the young bull market of 2020 can’t endure, according to Ned Davis Research.

“The leverage cuts both ways,” strategists including Ed Clissold wrote in a note. “The same forces that amplified the parabolic moves in August and early September are enabling the downside momentum as the calendar moves deeper into September.”

To be sure, the timing of the recent pullback isn’t unusual. The research firm’s analysis shows the economic cycle is near the point at which stock market gains should slow down. At the same time, in baby bull markets past, the largest corrections have occurred a median 4.5 months into the equity comeback. Plus, stocks are facing a period of weak seasonality and election uncertainty.

“The strange option volatility may have been the trigger to the recent pullback, but it came at a time when economic, stock market, election, and seasonal cycles were lining up,” Clissold wrote. “Whether this proves to be a cyclical peak or a bull correction will depend on how much damage technical indicators take as excessive optimism is worked off.”

©2020 Bloomberg L.P.

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