In the stock market, all is not as it seems.
A slowdown in inflation has boosted investor confidence in the economy this year and, combined with a strong appetite for artificial intelligence, has provided the backdrop for growth that has beaten 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 more volatility to come is near an all-time low.
But a look beneath the surface reveals much greater turbulence. Nvidia, for example, whose stock price surge helped it become America’s most valuable public company last week, is up more than 150 percent this year. The price has it also experienced deep declines repeatedly in the past six months, shaving billions of dollars off its market value each time.
More than 200 companies, or roughly 40 percent of stocks in the index, are at least 10 percent below their highs this year. Almost 300 companies, or roughly 60 percent of the index, are more than 10 percent above their lows for the year. And each group includes 65 companies that have actually moved in both directions.
Traders say this lack of correlated movement – known as dispersion – between individual stocks is at historical extremes, undermining the idea that markets are shrouded in calm.
One measure of that, an index from exchange operator Cboe Global Markets, shows that the spread increased after the coronavirus pandemic, as technology stocks rose while shares of other companies suffered. It has stayed high, in part because of the skyrocketing valuation of some select stocks at the highest AI advantage, analysts say.
That’s presenting an opportunity for Wall Street, as mutual funds and trading desks flock to spread trading, a strategy that typically uses derivatives to bet that index volatility will remain low while turbulence in individual stocks will to stay high.
“It’s everywhere,” said Stephen Crewe, a longtime dispersion trader and partner at Fulcrum Asset Management. He believes that these dynamics have surpassed even the most expected economic data in terms of their importance for financial markets. “At the moment it hardly matters about GDP or inflation data,” he added.
The risk for investors is that stocks will start moving in the same direction again, all at once — most likely because of a spark that ignites widespread selling. When this happens, some fear that the role of complex volatility trades could change and, rather than mitigate the appearance of turbulence, exacerbate it.
Dispersion trading.
Estimating the total size of this type of trade is challenging even for those involved in the market, in part because there are multiple ways to make such a bet. Even in its most basic form, distribution trading can involve several different financial products that are bought and sold for many other reasons as well.
How big is it? “That’s a million dollar question,” Mr Crewe said.
But there are some clues. The options market has grown — the number of contracts traded is set to exceed 12 billion this year, according to Cboe, from 7.5 billion in 2020 — and while there have always been specialists with quirky derivatives strategies, now more mainstream fund managers are said to be . to accumulate.
Assets in mutual funds and exchange-traded funds that trade options, including distribution trading, grew to more than $80 billion this year, from about $20 billion at the end of 2019, according to Morningstar Direct. And bankers who offer clients a way to replicate sophisticated trades but without specialized knowledge say they’ve seen an increase in interest in distribution trading.
But while its intent may not be fully known, this perceived influx of funds has raised comparisons with the last time volatility trading became popular, in the years leading up to 2018.
At the time, investors had piled into options and leveraged exchange-traded products that boasted huge gains in muted markets but were highly susceptible to sharp selloffs that increased volatility. These trades were explicitly “volatility short,” meaning they profited when volatility fell, but lost heavily when the market became choppy.
So when quiet markets suddenly imploded and the S&P 500 fell 4.1 percent in one day in February 2018, some funds were wiped out.
While this dynamic continues, analysts say it is much less important and that the advent of popular distribution strategies is fundamentally different.
Because the trade seeks to profit from the difference between low index volatility and significant swings in individual stocks, even in a violent selloff, the outcome is usually more balanced, with one stock 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 can still land investors in trouble. This potential outcome is part of the reason why dispersion trading is getting so much attention right now – everything could be good, but it’s very hard to know for sure, and what if it isn’t?
“Firewood is very, very dry,” said Matt Smith, a fund manager at Ruffer, a London-based asset manager. “And there are many things in the world, so the weather is hot.”
Relaxation can be ugly.
More importantly, the largest companies in the market are also distributed. Microsoft, a beneficiary of the AI enthusiasm, is up 20 percent this year. Tesla is down 20 percent. Nvidia remains the periphery, 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, particularly other technology companies such as Microsoft and Alphabet.
Calm seemed to prevail, despite a sharp drop in one of the index’s biggest components.
When very large stocks start falling in concert, as they did in 2022, the result can be painful. Distribution trading can make it all worse.
If the S&P 500’s volatility spikes more because a stock like Nvidia falls, but the damage is contained to specific technology or AI sectors, an asymmetric outcome would punish many dispersion trades, according to industry specialists. Losses can increase as traders looking to cut their losses make trades that exacerbate volatility.
This possibility is hypothetical. Nvidia still hasn’t slowed down demand for its chips, and its revenue continues to skyrocket. The deleveraging could continue for some time given this unusual market dynamic, bankers and traders said.
But for some specialist investors more experienced in the complexities of distribution trading, trading has lost its luster as it has been pushed to ever more extreme levels.
Naren Karanam, one of the market’s biggest dispersion traders, who trades at hedge fund Millennium Partners, has scaled back his activity, seeing fewer opportunities for profit, people with knowledge of his decision said. A rival hedge fund, Citadel, lost its chief distribution trader in January and chose not to replace the person.
Even some who remain in the market say that the current extreme dynamics, with index-level volatility so low and individual stock spreads so high, leave them with little appetite to increase their trading. Others are starting to take the opposite side of the trade, hedging against a choppy 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 is a limit.”