Options Gamma and the Trump Trade Peril for Volatility Funds

  • Bets on calm market fall flat as rally pushes equities higher
  • Selling volaility a popular strategy in low-yield environment

Bet on peace and quiet under Donald Trump? You lost.

It’s true in Washington and it’s increasingly true in markets, where one hedge fund trade -- that prices will sit still -- showed cracks this week. Blame it on the rally that added $500 billion to U.S. equity prices in five days, lifting the S&P 500 to successive records.

One manager has been caught out already, Catalyst Capital Advisors, whose rush to cover wrong-way options bets transfixed traders speculating that forced buying helped lift the S&P 500 earlier in the week. Pain in the so-called short gamma trade is another byproduct of the shifting landscape under Trump, whose election ended two years of paralysis in equities.

“If the market or just one big whale gets caught off-sides as you get close to expiry, it can be very unpleasant, and they have to do this frantic buying back,” said Michael Purves, chief global strategist at Weeden & Co. in Greenwich, Connecticut. “That can have ripple effects where others short the market may need to cover now too.”

Fissures in short gamma, trader talk for bets that prices will stay quiet, have been blamed for any number of market curiosities this past week, among them a concerted move in the VIX and S&P 500 on Wednesday. Though Catalyst Chief Executive Officer Jerry Szilagyi played down claims his fund was moving the market, he said his job has gotten harder.

“We’ve communicated with our shareholders over the years that this is the type of environment that’s the worst for the fund,” said Szilagyi. “We’ve had losses before and when this happens, we’ve covered our positions, and when market conditions are more favorable we’ll get back in.”

Catalyst Hedged Futures Strategy Fund, the portfolio involved in the call trade, saw its net asset value tumble for seven straight days -- a stretch that coincided with the longest streak of gains in the S&P 500 since September 2013. The $3.4 billion fund, founded in 2006 by a former supply-chain management specialist named Ed Walczak and brought under the Catalyst umbrella in 2013, was down 13.5 percent in 2017 through Wednesday. It climbed 0.6 percent yesterday.

Neutral Positions

Over the past few months, the fund went short on call options that expired this week, before buying them back as the market rallied, Szilagyi said. Catalyst’s positions are now neutral -- news that itself may have contributed to a dip in U.S. stocks on Thursday as traders reasoned there was one fewer buyer for futures.

“People have nothing better to talk about right now, so this kind of gets blown out of the water,” Amy Wu Silverman, managing director and equity derivatives strategist at RBC Capital Markets LLC, said by phone. “You can see the market traded off the announcement that it wasn’t happening anymore so I think the two are related.”

The Huntington, New York-based fund’s strategy of selling volatility has been a popular one amid today’s low interest rate environment. But the force of recent equity gains has thrown that income earning strategy for a loop, burning anyone who was banking on muted moves.

Relentless Market

“If volatility picks up and things move around more, it’s going to be much harder on those firms selling options,” said Matt Friedman, senior vice president of options trading at Convergex Group LLC, in New York. “They’re going to have a harder time outperforming as we continue to move higher and break out of range.”

Hedge funds that were shorting options on S&P 500 futures then bought them back because of the recent stock rally might have caused the VIX to jump 11 percent on Wednesday, according to Michael Block of Rhino Trading Partners. The volatility index and the S&P 500 have been moving together 29 percent of this year’s trading days, the most since 1995, data compiled by Bloomberg show.

The options market was particularly busy on Wednesday, with almost 22 million contracts on U.S. securities trading, the most this year, according to data from the Options Clearing Corp. The open interest for S&P 500 contracts has climbed 31 percent since the January monthly expiration, the biggest increase since last May. Monthly options expire on Friday.

“The relentlessness of the market has caught a lot of people off-sides,” said Purves. “It’s the nature of the beast and people who buy these products should understand this.”

— With assistance by Gregory Calderone, and Cecile Vannucci

    Before it's here, it's on the Bloomberg Terminal.