The wild swings led by oil since the start of the Iran war have institutional investors turning to exotic hybrid options to trade cross-market gyrations.
Oil prices swung almost $36 a barrel on March 9, the biggest one-day range on record, triggering sharp intraday reversals in assets from stocks and bonds to gold and the dollar. Implied volatility measures spiked as traders sought cover from massive swings.
Turning to bonds and gold for protection from soaring crude prices hasn’t worked as stagflation concerns have gripped markets. A protracted shutdown of the Strait of Hormuz would mean higher costs not just for oil, but also for natural gas, plastics, aluminum and fertilizer — feeding in to widespread inflation.
Money managers looking for opportunities as the usual relationships break down are putting on over-the-counter cross-asset hybrid options. The unusual range of moves across rates, commodities and equities have seen significant trading activity in dual binary and contingent options.
“The hybrid market has experienced a significant surge in activity, in line with heightened geopolitical risk and a flight to safety among investors,” said Antoine Porcheret, head of institutional structuring for the UK, Europe, the Middle East and Africa at Citigroup Inc. “Volumes have notably boomed as all types of investors actively put on further dual digital hedges.”
Hybrid option plays are typically structured in two ways: standard options with a condition on another asset class or dual binaries.
The dual binary (or dual digital) is an all-or-nothing play: in exchange for a premium, the trade either returns 100% or nothing. While critics say it’s more akin to betting on a sporting event than traditional options trading, the reality is that such a binary payoff is extremely useful to investors focused on hitting target returns within strict risk limits. Prediction market firms have branched out from event markets to offer some wagers on the S&P 500 Index.
While dispersion trades on either volatility or outright moves continue to be active within single stocks, they’re less common across assets. However, investors who played a similar theme within the cross-asset space this year would have seen wider realised dispersion due to the spike in oil prices.
European stock markets continue to be hit hardest by the conflict, underperforming US equities and causing investors to wash out of bullish positioning — especially in the region’s banks, according to some derivative strategists.
The Stoxx Europe 600 Index is the most negatively correlated to Brent crude since 2003, according to data compiled by Bloomberg. While oil up/equity down dual binary options were not very popular into the end of February, since the start of the conflict the flows have been trading both directions, signaling many traders were willing to fade the oil price spikes.
To play a continuation of current trends, Barclays Plc derivatives strategists favor put spreads on the Euro Stoxx 50 Index or the S&P 500 conditional on higher interest rates, which give about a 72% discount versus vanilla put spreads. The strategists also pitched the S&P 500 down/US Oil Fund up dual binary offering better than 10:1 leverage.
“EQ/rates has traded, but not particularly more than traditional safe-haven and commodity assets, including gold, the Japanese Yen, the US dollar and oil,” said Citi’s Porcheret.
There are some signals in the listed market of the increase in binary options demand. Volume of very tight crude oil call spreads has picked up, likely a sign that market makers are hedging OTC binary options.
The big question for market participants is whether the war will be over quickly or if this will be an extended operation. That may determine whether current cross-asset trends will prove sticky in a prolonged conflict, or whether a more widespread bear market will develop that would see correlations rise across assets as investors deleverage.
“While the direction in equities has leaned bearish too, the outlook remains more debatable, with some investors taking the advantage of the selloff to reload bullish positions,” Porcheret said.
