Smart Money Had the Jump on Another Mid-Month Plunge in S&P 500
(Bloomberg) -- Whether hedging for options expiration, worsening virus sentiment or just a selloff adhering to a calendar quirk, investors were ready Tuesday for the S&P 500 Index’s worst drop in a month. It may leave them armed for a rebound.
Traders who loaded up on protection against a selloff are cashing in Tuesday, as the S&P 500 fell 0.7% to halt a five-day winning streak. The Cboe Volatility Index, or VIX, spiked as high as 19.6, a level last seen more than two weeks ago.
People bought protection as equities steadily marched higher, a phenomenon that in itself may make the downturn short-lived, according to Art Hogan, chief strategist at National Securities. Dips have been bought all year as investors jumped back in, riding a rally that’s seen the S&P 500 avoid a 5% pullback for almost 200 days.
“Leaning into the inevitable increase in volatility after so much calm in the markets makes sense in the near-term,” Hogan said. “‘We got this right, so let’s unwind this trade.’ And unwinding that trade likely will be the spark that turns volatility in the other direction, meaning, ‘Let’s get back into equities here, that was it, nothing to see here, move on.’”
Options traders have kept their guard up in August, a month that before Tuesday was shaping to be the calmest in two years. The Federal Reserve is expected to announce plans on rolling back its monetary stimulus in coming weeks while the risk of another wave of Covid infections lingers. Add a potential Chinese slowdown and the chaos in Afghanistan, and it was a recipe for nervousness.
Heading into this week, the angst was particularly acute in derivatives tied to the VIX. A measure of implied volatility in VIX options, the VVIX, on Friday reached the highest level relative to the VIX since before the Covid-19 pandemic. In the futures market, six-month contracts on the VIX traded at 7.7 points above the cash index, a premium that before this year hadn’t been seen since 2016, data compiled by Bloomberg show.
To Michael Purves at Tallbacken Capital Advisors, heightened interest for hedging is a sign that sentiment has yet to turn overly exuberant and there are still skeptics that can be converted into buyers.
“It actually reflects healthy non-complacency in the equity land,” Purves said. “It’s also a reason why it ultimately helps to push the market higher.”
Jarring, mid-month selloffs have been a regular feature of markets this year and have done little to deter stocks’ march to records. In July, the biggest downdraft was a 2.7% slide over the three sessions through the 19th. In June, the share benchmark lurched 1.3% on the 18th, its largest fall of the month. May saw a three-day decline ending the 19th knock 1.4% off the index, though a plunge the week before was a bit bigger. And a 1.2% drop over two days ending April 20 was that month’s worst.
It could just be coincidence. Another possibility is that it has something to do with a wonky market event that also occurs right around the middle of every month -- options expiration, which in August comes this Friday.
Why exactly the monthly expiration of contracts to buy and sell shares would cause this is not entirely clear. But at least one Wall Street veteran sees the event as a catalyst for potential turbulence. Charlie McElligott, a cross-asset strategist at Nomura Securities, says dealers who are hedging their options positions by buying or selling underlying stocks have become “long gamma,” meaning they need to push against the prevailing market trend and act as a buffer to the downside. Once options expire, that floor disappears, leaving the market vulnerable to negative shocks.
To Alon Rosin, Oppenheimer’s head of institutional equity derivatives, the recent weakness surrounding option expiry was likely a random occurrence. “If anything, what we’ve been seeing and the way what we’ve been playing it is, option expiry typically had a better bid to it off expiration-related flows,” he said. “All the dips have been bought. What we are seeing into August expiry this Friday is a lot of open interest below around 4,440 and 4,450” on the S&P 500.
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