Sleepy equity options jolted by renewed U.S.-China trade tensions

NEW YORK (Reuters) - Months of calm in U.S. stocks gave way to a surge in activity in the options market on Tuesday as investors spooked by escalating trade tensions between the United States and China boosted Wall Street’s so-called fear gauge to the highest level in three months.

Traders work on the floor at the New York Stock Exchange (NYSE) in New York, U.S., May 7, 2019. REUTERS/Brendan McDermid

Wall Street’s main indexes tumbled about 2% on Tuesday as investors shunned risky assets.

The Cboe Volatility Index, a widely followed options-based barometer of expected near-term volatility for stocks, known as the VIX, rose about 5.56 points to 21, its highest close since Jan. 23. The index has logged an average close of 13 over the last month.

“I think it is pretty clear that this is all driven by the trade issue,” said Randy Frederick, vice president of trading and derivatives for Charles Schwab in Austin, Texas.

U.S. officials have accused China of backtracking in the past week on substantial commitments made during months of negotiations aimed at ending their bruising trade war, prompting President Donald Trump to issue a Friday deadline to raise tariffs on $200 billion worth of Chinese goods to 25 percent from 10 percent.

The surge in trade-related uncertainty comes just after U.S. stocks reached record highs, and if the higher volatility is sustained it could indicate further trouble for Wall Street.

“The upside to be gained when we get this trade issue resolved with China is relatively small. The downside is significant,” Frederick said.

On Tuesday, overall options volume was set to hit 25 million contracts for the day, or about 40% more than the daily average over the past month, according to options analytics firm Trade Alert.

A lot of the activity was concentrated in contracts that expire by the end of the week, which corresponds to Trump’s Friday deadline for additional tariffs.

For S&P 500 options, contracts expiring by the end of the week sported a volatility of about 26%. This was higher than for any other expiration, pointing to investors’ focus on risk in the very near term.

“We maintain a cautious outlook for the S&P 500 as momentum, volatility and breadth indicators suggest a difficult environment for U.S. equities over the coming weeks,” Peter Cecchini, chief market strategist at Cantor Fitzgerald, said in a note on Tuesday.

The VIX was on pace for its largest one-day gain since Dec. 24.

Some of the gains in the VIX may have to do with some investors having to cover short positions in VIX futures that had grown to near record proportions in recent months, Weeden & Co derivatives strategist Michael Purves said.

Speculative short positions in VIX futures were at their largest since early October and close to the largest they have been in about two years, according to the latest data from the Commodity Futures Trading Commission.

“Aggressive positioning does not become a volatility catalyst, but if you get a volatility catalyst the short covering becomes a magnifier of the move,” Purves said.

Despite the surge in defensive activity on Tuesday, investors were not hitting the panic button yet, analysts said.

“It’s the kind of activity you would expect when markets fall 1 to 2 percent in a year when equities have largely only gone up,” said Anand Omprakash, head of derivative quant strategies at BTIG in New York.

“Equities in general have had a wonderful run since January. If the market is indeed turning, I think some investors may be trying to get ahead of that,” he said.

Reporting by Saqib Iqbal Ahmed; Editing by Alden Bentley and Leslie Adler