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Funds Utilizing Option Selling Tactics Help Dampen Swings in US Stocks

The recent volatility witnessed in U.S. stocks may be tempered by the presence of popular funds employing options selling strategies, extending their influence in stabilizing the market over the past few months.

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According to Morningstar data, assets under derivative income Exchange-Traded Funds (ETFs) – funds utilizing a blend of stocks and stock derivatives to generate income – have surged from $33 billion to approximately $71 billion since the end of 2022.

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Experts in options trading suggest that these funds, alongside other options-selling strategies, have contributed to moderating fluctuations in stock prices, a factor that has prolonged the period of market stability. The decline of the Cboe Volatility Index (VIX), often referred to as Wall Street’s “fear gauge,” to its lowest level in two months in late March is attributed partly to robust earnings and expectations of forthcoming rate cuts.

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These trades are believed to have assuaged recent volatility as the VIX approached a seven-week high, amid concerns that the Federal Reserve might not implement as many rate cuts as anticipated, potentially leading to an inflationary rebound.

While the S&P 500 hovers near record highs, it experienced two consecutive days of 1% swings last week, marking the first such occurrence in about two months.

Alex Kosoglyadov, Managing Director for Equity Derivatives at Nomura, identifies the presence of volatility-selling funds as a key moderating force amid market turbulence. He notes the significant growth in ETFs and mutual fund strategies engaged in options selling for income generation, emphasizing their observable impact on the market.

Various options selling strategies exist, including those selling calls, puts, or a combination thereof, with or without equity holdings. These strategies collectively contribute to mitigating market volatility.

For instance, some options selling ETFs generate income by selling out-of-the-money call options against their stock holdings. Market makers often hedge their exposure by selling stock index futures. As markets ascend, the ETFs repurchase the call options, prompting market makers to close their hedges by purchasing index futures, thereby bolstering stocks.

Kris Sidial, Co-Chief Investment Officer of volatility arbitrage fund the Ambrus Group, highlights the consistent influx of index volatility supply in response to spikes in volatility, contributing to sustained market stability.

However, while these options-selling strategies play a role in dampening market movements, they may not single-handedly prevent a significant selloff in the event of a drastic shift in the stock outlook.

Looking ahead, Wednesday’s consumer price data for March poses a potential flashpoint. A higher-than-expected reading could heighten inflation concerns, potentially undermining the case for interest rate cuts, a fundamental driver of the current bull market.

While past instances of volatility-induced turmoil, such as “Volmageddon” in February 2018, have raised concerns, experts suggest that the current landscape of options-selling funds differs structurally and is less concentrated, potentially mitigating systemic risks. Nonetheless, there remains a degree of apprehension regarding the potential consequences of rapid unwinding of these strategies in a volatile market environment.

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