Where Did All This Volatility Come From???
There’s so much happening now in financial markets. I feel this is a good time to share my thoughts and insights and hopefully more consistently each month. While I know reading emails is not top on everyone’s list of enjoyable activities, through this Newsletter I hope to share an idea or two that you’re probably not going to hear from the mainstream financial news. Thanks for reading, please respond with your thoughts and opinions and I always appreciate you sharing this with others you feel can benefit from it as well.
Where Did All This Volatility Come From???
So what is going on with markets this year??? Just to put some numbers around it, less than five months into the year the S&P 500 entered the so-called bear market territory of down more than 20%. The NASDAQ 100 was down over 30% at its low, and long duration bonds have traded down as much as 20% with almost indexes reaching year to date lows all in the month of May. In my opinion this selloff has less to do with real economic factors like inflation rising and more to do with liquidity being taken out of the market. For those wondering, liquidity is just whether or not money is being added or taken out of the market. A good way to think about it is that after March 2020 with the fear of a covid pandemic the federal reserve pumped in liquidity with low interest rates and bond buying. Markets responded by rising prices and the S&P 500 ended up 16% in 2020 and 26% in 2021. Now at the beginning of 2022 the Fed reversed those actions by raising interest rates and stopped their bond buying program essentially taking back the liquidity that they just pumped in. Just like the tide that comes in and raises all boats when the tide goes out all those boats go down but much faster. Last week we’ve seen a bit of recovery in what I would call a technical oversold bounce, however the bigger question remains of what’s going to happen over the next 2-3 months given that the Fed still has more interest rate rises planned and hasn’t even started their balance sheet reduction plan??? Well I’m not in the business of market forecasting, however I do rely upon some technical indicators to provide a sense of market trend and momentum.
What Do Options Have To Do With It???
If you’ve been a client of SEDNA Wealth Management you’ve probably listened to me at some point highlight the hedging strategies that are being used within the options markets and why investors should pay attention to option flows. This concept is fairly new to many as most financial advisors are generally not educated on the role that options play in driving market prices and overall volatility. It’s also a fairly complex discussion that’s definitely too lengthy (boring) to be included in this newsletter, but let me at least frame a story around how markets have changed since the financial crisis. Prior to 2008 Investment Banks (Goldman, Merrill, Morgan, etc.) played the primary role in helping institutions (insurance companies, pensions, etc..) hedge market risk. However after the implementation of the Dodd Frank Act, Investment Banks have pulled back the amount of hedging business they can or are willing to do. So large institutions gradually started looking at other ways to hedge their portfolios which led them to use the options market with greater and greater ease. Over the past 10 years plus the options market has grown in overall transactions and become a much bigger factor in what drives market prices and volatility with not only large institutions using it to hedge, but hedge funds and individual investors becoming active participants in monthly, weekly or even daily option strategies. Some of you may recall in January of last year the huge rise in GameStop and AMC’s stock in just a couple weeks and the role that retail investors buying of call options played in driving it. Well options have played a similar role in the downside of indexes and individual stocks during the first part of 2022, only it’s largely the institutional buying of puts that are driving things to the downside this time. During the month of May alone we’ve frequently seen major indexes like the S&P 500 and NASDAQ 100 selling 2%, 3% even 5% down in a single day. For the most part the selloffs have been rather orderly and consistent and while many factors contribute to market declines, we can’t ignore the impact of option positioning in determining the likely direction and size of market moves.
How Should Investors Position For Volatile Markets?
In my opinion, these periods of high volatility are likely to continue for the foreseeable future. Investors have to decide do they want their portfolio to be a passenger on a ship that gets thrown around by the waves of the market or do you take a more active approach to factoring in the hedging positions in the market and rotate a portion of your portfolio to manage market volatility. At SEDNA Wealth Management the goal is help our clients consistently smooth out returns and avoid the threat of large drawdowns. We have created two portfolio sleeves, called tactical opportunities and option premium harvesting to help clients take advantage of directional moves and the volatility in the market. These strategies are managed internally using both options market research and our proprietary technical analysis.
To learn more about the ideas featured in this paper or strategies at SEDNA Wealth Management please contact me at the information listed below.
Thank you for reading this month’s newsletter and sharing with others.
Rick Drew, Managing Director