After the S&P 500 index hit a new high in August, Wall Street's assessment of short-term risk-reward ratios began to shift. Citadel Securities believes that as September unfolds, the factors driving upward momentum for U.S. stocks are diminishing, while the triggers for downward movement are increasing. At the same time, option protection prices are at low levels for the year, making buying hedges more attractive.
Volatility decline reduces hedging costs
In a report to clients, Citadel Securities, Head of Equity and Equity Derivatives Strategy Scott Rubner, stated that this does not mean institutions have abandoned their medium- to long-term optimistic view of US stocks, but the risk-reward structure has changed in the short term.
He pointed out that the favorable factors that drove the S&P 500 index to set a new record in August are weakening. As the earnings season comes to an end, the prospects for corporate repurchases are changing, and coupled with seasonal factors and a slowdown in retail trading activity, the market's short-term support is not as evident as it was earlier on.
The S&P 500 index briefly rose to 7,816.70 points during the session this month. The index has gained nearly 7% from the end of July to the first week of August, but since then, its trend has turned weak and sideways. Meanwhile, the VIX Volatility Index Cboe fell to 14.1 last week, reaching its lowest level of the year.
Tech stocks' financial reports ease concerns about AI trading
Cboe Data shows that the previously high gap between the implied volatility of individual stocks and the volatility of the index is narrowing. The VIXEQ indicator, which measures the implied volatility of the top 50 components of the S&P 500, has seen a significant reduction in its related price difference.
Another change occurred in the volatility difference between the NASDAQ 100 and the S&P 500. According to Cboe data, the volatility spread between QQQ, which tracks the NASDAQ 100, and SPY, which tracks the S&P 500, has dropped from its historical high in June to a lower percentile over the past year.
Cboe, the head of derivatives market intelligence, Mandy Xu stated that tech companies' financial reports, which were stronger than expected, especially NVIDIA's performance last week, helped to reduce the volatility risk premium of tech stocks, and the market's concerns about AI transactions have eased.
Seasonal weakness in September leads to caution
Rubner believes that September has not only always been a month when U.S. stocks perform poorly, but also from the perspective of retail trading behavior tracked by Citadel, the buying momentum during this period is usually lower as well.
He stated that since 2019, on the trading days when the S&P 500 declined, the net buying volume by retail investors was approximately only half of the average level in September. This means that when the market enters a phase with a higher frequency of macroeconomic events, the support from retail investors may be weaker than in other months.
In Rubner, it seems that the current market is entering a period with a higher concentration of macroeconomic events, yet the premium that investors are willing to pay for downside protection is relatively low. This makes defensive positions and protective trades more attractive in the short term.
