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Investors are opting out of “whack-a-mole” software sales by resorting to protection against volatility and taking advantage of the difference in sectors becoming winners or losers from AI advancements.
Some of Wall Street’s biggest players are turning to complex options and hedging strategies to navigate a market filled with blog posts and headlines that have recently wiped billions of dollars off the value of some of the S&P 500’s biggest tech groups.
A 10,000-word post on Substack on Monday detailing a future in which AI will hollow out consumption by increasing unemployment prompted a new wave of selling in the software and private capital sectors.
A few hours later, Anthropic said its new Cloud Code AI tool could soon replace the widely used computer programming language. IBM shares immediately fell 13 percent, the company’s worst one-day decline in more than 25 years.
“For years and years everything moved in lockstep. But the recent moves have been very, very dramatic in both directions,” said Charles Lemonides, founder of hedge fund ValueWorks. “The swings are just crazy.”
Faced with such feverish markets, stock picking has become a matter of “surviving the blowout,” said Mike O’Rourke at Jones Trading.
Investors are adopting so-called spread trades, which involve buying single-stock volatility while selling index volatility to profit from the difference between relatively small daily moves of the S&P 500 and large price fluctuations for individual companies.
The S&P 500 has gained just 1 percent and traded within a 2.7 percent range since the beginning of the year, “the hardest in a century outside of 1964 and 1966,” according to Barclays analysts. But “this calmness at the macro level masks wild fluctuations at the micro level”, he added.
Citadel Securities said last week that the gap between individual stock moves and the S&P’s relative stability is the widest since the global financial crisis in 2009.
“The net dollar number that is chasing (spread trading) is larger than before,” said Anshul Gupta, head of quantitative investment strategies at Barclays.
“Fast money accounts like hedge funds are a lot more active… but you’re also seeing the application of this (trading strategy) expanding far beyond hedge funds,” he said, adding that asset managers and pension funds are increasingly active.
Jason Goldberg, a senior portfolio manager at Capstone Investment Advisors who specializes in spread trades, said the ratio of short-dated stock option prices to index option prices has risen sharply. “The options market is telling you it expects a high spreads environment,” he said.
Manish Kabra, head of US equity strategy at Societe Generale, said money manager clients were inquiring about spread products to allow them to trade the split in the tech sector between perceived winners and losers from AI disruption.
“Someone’s going to win, we don’t know who, but we want to play the full spread,” Cabra said.
Other investors are looking for ways to protect their portfolios amid the market turmoil.
Charlie McElligott, managing director of global equity derivatives at Nomura, said “institutional client hedging has been relentless” in response to “the flood of negative catalysts for equities” and the ongoing “market destruction game.”
McElligott said Nomura clients, including several software companies, have stepped up buying of puts on Invesco’s Senior Loan Exchange Traded Fund and the iShares High Yield Corporate Bond ETF.
In a note to clients this week, JPMorgan touted its so-called “triple edge hedging framework” for investors looking for a “disciplined way to manage episodic pullbacks.”
When market volatility increases, the bank suggests buying “convex” short-dated S&P 500 puts that become increasingly expensive during sudden and severe selloffs. “The strategy moves towards more cost-efficient payments during quieter periods,” the bank said.
Lisa Shalett, head of Morgan Stanley Wealth Management’s global investment office, said traders are meanwhile shorting consumer discretionary stocks while going long in the industrials sector – a “pair trade” driven by early signs of weak consumption and bets on stocks that could benefit from building the infrastructure needed to power the big language models.
If the market experiences a broader shock – perhaps from escalating geopolitical risks or trade wars – that causes stocks to decline in unison, spread trading may be disrupted.
In that case, investors who have bet on spreads could be forced to buy index-level volatility protection, potentially exacerbating a market-wide selloff, according to Jasmine Yeo, fund manager at Ruffer.
