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 fervor for artificial intelligence, provided the backdrop for a rally that has exceeded all expectations.
The S&P 500 climbed 15% in the first half of 2024.
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 followed measure of bets on greater volatility to come 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 has also experienced several deep drops over the past six months, wiping out billions of dollars of market value each time.
More than 200 companies, or about 40% of the stocks in the index, are at least 10% below their highs of the year. Nearly 300 companies, or about 60% of the index, are more than 10% above their lows of the year. And each group includes 65 companies that have 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 turbulence on individual stocks will remain high.
“It’s everywhere,” said Stephen Crewe, a longtime trader and partner at Fulcrum Asset Management. He believes these dynamics have outpaced even the most anticipated economic data in terms of importance to financial markets. “GDP or inflation data are almost irrelevant right now,” he added.
The risk for investors is that stocks could suddenly start moving in the same direction again – perhaps because of a spark that triggers widespread selling. When that happens, some worry that the role of complex trading on volatility could reverse and, rather than dampen the appearance of turbulence, exacerbate it.
The dispersion trade.
It is difficult to estimate the total size of this type of trading, even for those integrated into the market, partly because there are multiple ways to make such a bet. Even in its most basic form, spread trading can include several different financial products that are also bought and sold for many other reasons.
How big is it? “It’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 derivatives strategies, there are now says more traditional fund managers are interested.
Assets in mutual funds and exchange-traded funds that trade options, including spread trades, have grown to more than $80 billion this year, up from about $20 billion at the end of 2019, according to Morningstar Direct. And bankers who offer clients a way to replicate sophisticated trades without specialized knowledge say they’ve seen a surge in interest in spread trading.
But while its full extent cannot be fully known, this perceived influx of funds has raised comparisons to the last time volatility trading became popular, in the years leading up to 2018.
At the time, investors flocked to options and leveraged exchange-traded products, which offered high returns in flagging markets but were highly susceptible to selloffs that increased volatility. These trades were explicitly “short volatility,” meaning they benefited when volatility fell, but suffered heavy losses when the market became turbulent.
So when markets suddenly calmed down and the S&P 500 fell 4.1% in one day in February 2018, some funds were wiped out.
Although this dynamic persists, analysts say it is much less significant and the advent of popular dispersal strategies is fundamentally different.
Since the trade seeks to profit from the difference between low volatility in the index and large swings in individual stocks, even in the event of a violent sell-off, the result is generally more balanced, with a portion likely to increase in value while the other decreases.
But even this generalization depends on how the transaction was executed, and certain circumstances can still put investors in difficulty. This potential outcome is part of the reason why dispersion trading is getting so much attention right now: everything could go well, but it’s very difficult to be sure, what if it doesn’t?
“The 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.
Importantly, the market’s largest companies are also scattered. Microsoft, a beneficiary of the AI enthusiasm, has grown its revenue by 20 percent this year. Tesla has fallen by 20 percent. Nvidia remains the exception, with stunning gains.
So even on a day like Monday, when Nvidia fell 6.7 percent, the S&P 500 only fell 0.3 percent. The broad index was supported by other stocks, particularly other mammoth 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 very large stocks all start falling in unison, as they did in 2022, the result could be painful. Dispersion trading could make things worse.
If S&P 500 volatility spikes because of a stock like Nvidia’s decline, but the damage is limited to specific technology or AI sectors, an asymmetric outcome would hurt many spread trades, industry insiders say. Losses could deepen as traders looking to cut losses make trades that exacerbate volatility.
That 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 Partners, has scaled back his activity, seeing fewer profit opportunities, people with knowledge of his decision said. A rival hedge fund, Citadel, lost its head of dispersion in January and chose not to replace him.
Even some of those remaining in the market believe that the current dynamic, with such low volatility at the index level and such high dispersion of individual stocks, leaves them reluctant to increase their trading. Others began taking the opposite side of the deal, protecting themselves against a stormy sale.
“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.”