ANALYSIS-Funds sell options to help cushion U.S. stock volatility

Saqib Iqbal Ahmed and Suzanne McGee reported.

NEW YORK (Reuters) - Popular funds that sell options for gains may be moderating recent volatility in U.S. stocks, continuing the calming effect they have had on the market over the past few months.

Derivative income ETF funds that utilize equities and equity derivative portfolios to generate income have increased in assets from US$33 billion at the end of 2022 to approximately US$71 billion, according to Morningstar.

Some options mavens argue that these funds and other options-selling strategies have moderated stock volatility, another reason for the stock market's prolonged calm. The Cboe Volatility Index, Wall Street's "fear index," fell to a two-month low in late March as strong earnings and expectations for interest rate cuts this year sent stocks higher.

The trades may also have tempered recent volatility as the VIX index has climbed to hover around the seven-week high of 16.92 set last Friday, amid growing concern that the Fed may not cut rates as sharply as expected without a rebound in inflation.

The Standard & Poor's 500 Index (S&P 500) is near all-time highs, but last week saw two consecutive days of 1% volatility for the first time in about two months.

While several factors may have kept volatility from intensifying further, the presence of sell-off volatility funds is a mitigating force, says Alex Kosoglyadov, managing director of equity derivatives at Nomura Securities (Nomura).

"These ETFs, QIS (quantitative investment strategies) and mutual fund strategies that sell options for income have seen tremendous growth," says Kosogliadov." We see it every day. It is definitely having a noticeable impact on the markets.

Strategies for selling options can take many forms, including selling calls, puts, or a combination of these options, with or without holding stock. The diversity of these strategies makes it difficult to assess the exact effect they may have on the market on a given day. Nevertheless, the combination of these options can moderate market volatility.

For example, some ETFs that sell options generate income by selling out-of-the-money call options (a person's name with a strike price much higher than the market trading price).

Market makers on the other side of these trades - institutional players such as large banks - usually hedge their exposure to bullish contracts by selling stock index futures. Where the market moves higher, as it has in recent months, ETFs are forced to buy back the sold calls, prompting the market makers to buy the futures to close their hedges and support the stock market.

"That's one of the reasons volatility has been so low over the last couple of years," said Kris Sidial, co-principal investment officer at Ambrus Group, a volatility arbitrage fund.

Each surge in volatility is accompanied by "a big wave of supply of exponential volatility," Sidiar said.

Maxwell Grinacoff, an equity derivatives strategist at UBS, said that while these options-selling strategies have served to moderate market moves in the background, they alone may not prevent a big drop in stocks if the outlook for the stock market changes fundamentally.

"To me, that's why the volatility is so low," Grinacoff said.

A potential flashpoint comes on Wednesday, when the U.S. releases consumer price data for March.

Higher-than-expected data could exacerbate inflation concerns and further undermine the case for rate cuts-which have been a key driver of the bull market that has lifted the S&P 500 about 26% from its October 2023 low.

Shorting volatility has a well-tested trading record on Wall Street, and in February 2018, a volatility-tracking note called the VelocityShare Daily Inverse VIX Short Term ETN broke the buck in what was dubbed "Volmageddon" as the market In February 2018, a volatility-tracking note called VelocityShare Daily Inverse VIX Short Term ETN went bust in an event known as "Volmageddon" as a result of a spike in market volatility, costing investors nearly $2 billion in assets.

Grinacoff and other options market participants are skeptical that current option sales funds pose the same systemic risks because they are differently structured and less centrally positioned than those of the past.

Still, some market participants are concerned about what might happen if these strategies are closed out in a hurry.

"Where volatility increases and you're dealing with derivatives, it's very difficult to know what's going to happen and when," said Ed Clissold, chief U.S. strategist at Ned Davis Research.

(Reporting by Saqib Iqbal Ahmed and Suzanne McGee; Additional reporting by Laura Matthews; Editing by Ira Iosebashvili and David Gregorio)