The Short Vol Trade Is Back: Why Some Investors Think It’s Driving Tranquility in Markets
Investors are pouring money into derivative-income funds that sell options contracts to juice income
The stock market is calmer than it has been in years. Some worry that a popular strategy is contributing to the tranquility.
Measures of market volatility have fallen to levels last seen in 2018, while major stock indexes have climbed to repeated all-time highs. The S&P 500 is up 9.7% in 2024 and has set 20 closing records.
Investors are responding. They are seeking protection from potential losses by pouring money into what are known as derivative-income, or sometimes covered-call, exchange-traded funds that sell options contracts in a bid to juice income or boost their returns. Options are contracts that allow the holder to buy or sell shares at a predetermined price.
Assets in such funds topped $67 billion at the end of February, according to Morningstar Direct, up from about $7 billion at the end of 2020.
The funds work by primarily investing in stocks like Tesla and Meta Platforms or major indexes such as the S&P 500 and Nasdaq-100. A fraction of the fund’s assets are used to sell a call option on assets the fund already owns, in exchange for an upfront payment called a premium. The buyer of the option has the right to purchase the underlying shares at a specific price, known as a “strike.”
The funds tend to perform best in a sideways market when stocks don’t move up or down too quickly. During market slumps, they often fall less than traditional portfolios. The flip side is that investors can be locked out of potential gains when stocks stage a big rally.
Of course, the funds come with other risks. Some of the funds, like a popular Tesla ETF, offer eye-popping yields that can leave investors deeply in the red if the market turns against them. The Tesla fund is susceptible to the wild swings in the electric-vehicle maker’s stock and sells options tied to the shares to generate income. It is far from the conservative alternative that some might expect of an income-generating fund and has fallen 34% this year, compared with Tesla’s 31% decline.
Wall Street portfolio managers have chalked up the interest in these funds to investors who are eager for regular income or looking to protect against large losses after a big rally, particularly as they near retirement age.
“We are at all-time-highs, and demand for this strategy has increased. I don’t think that’s a coincidence, and I do think it’s a function of demographics,” said Eric Metz, president and chief investment officer at SpiderRock Advisors.
The rise of the funds was propelled by a 2020 Securities and Exchange Commission rule that made it easier for ETFs to buy and sell options. The largest fund in the class, the JP Morgan Equity Premium Income ETF, has about $32.8 billion in assets under management and has returned 13% since its inception in May 2020. The S&P 500 has returned 17.2% over the same period.
One possible reason for concern: The funds are a different take of the short-vol trade that blew up in spectacular fashion six years ago. A February 2018 surge in stock market turbulence led to the collapse of two volatility exchange-traded products in an episode that became known as “Volmageddon,” causing huge losses for many individual investors. The blowup rippled through the broader market and fueled further selling.
This time around, investors are skeptical that the funds will trigger a repeat.
“That option structure is relatively benign in the grand scheme of things,” said Jim Carroll, a portfolio manager at Ballast Point Wealth Management. “There’s no detonation event that’s conceivable in that structure.”
Steve Bohn, a biotech executive from Highlands Ranch, Colo., uses a strategy that is similar to the derivative-income funds. He invests in a custom bank note that sells calls to generate income and protect against downside risk. He says he became comfortable with the idea after conversations with his financial adviser.
“I just wanted to understand, what is the maximum downside and how would I feel if I lived out that worst case scenario,” he said.
Bohn, who is 57 years old, estimated his portfolio would incur a $50,000 loss if his note lost all its value. “I wouldn’t be thrilled with it, but it wouldn’t mess up my life,” he said.
The interest in derivative-income investments is part of a broader options boom that has reached new heights to kick off 2024. Traders have flocked to bold, bullish bets on Nvidia and semiconductor stocks in particular.
By one measure, trading in options has surpassed that in stocks for the first time since 2021, according to Goldman Sachs. That is based on the notional value, a measure of how much the shares underlying option contracts are worth, a figure that fluctuates with daily moves in the shares. At times, the surge in options trading has fueled concerns that the derivatives activity could stoke volatility in the broader market.
Right now, volatility could hardly be lower. The Cboe Volatility index, or VIX, known as Wall Street’s fear gauge, closed Friday at 12.91. It has closed below 16 for 97 consecutive trading days, the longest such streak since 2018, according to Dow Jones Market Data.
Some worry that the rise of option-selling funds is contributing to the calm. The fresh supply of options means dealers, who generally don’t want to take a directional bet, need to hedge their risks, said JPMorgan Chase analyst Bram Kaplan. In this situation, that means buying stock futures when markets decline and selling them as they rise, serving as a counterweight to market moves and suppressing tumult.
“Call overwriting ETFs have become a large source of volatility supply that has been increasingly weighing on market volatility levels, in our view, ” Kaplan and other analysts wrote in a research note.
Even if the rise of option-based ETFs won’t spark another Volmageddon, some fear that current market conditions make the strategy unlikely to thrive.
“I love a short-vol trade. I get interested when VIX is 20, excited when it’s at 30,” said Rob Arnott, founder and chairman of Research Affiliates. At the current level, “it’s not exactly the trade of the decade,” he said.