The threat of a stock market sell-off is growing, according to Bank of America. Here’s how investors can protect themselves from ‘fragility,’ and a simple options strategy that will buy them more upside.
- Bank of America says investors are underrating the risk of a stock sell-off this fall.
- It says “fragility” due to low volatility and crowding have increased dramatically.
- The bank explains two options trades investors can use to protect themselves and also profit.
The stock market has been fairly calm recently, and if that’s the kind of thing that concerns you, Bank of America says you’re right to worry.
For the last few years, the bank’s equity derivatives research team has been warning investors about growing fragility in the stock market — a well-known phenomenon with disputed causes.
Bank of America calls fragility “violent dislocations in asset prices arising out of a confluence of low trading
, central bank-fueled investor psychology and resultant crowding.”
In late 2019, BofA’s global equity derivatives researchers said research into thousands of ETFs showed that three factors are often signs of fragility. The first two are fading momentum and low-or-falling volatility.
“We find assets where volatility remains low as momentum rolls over are more likely to witness a fragility shock – indicative of a crowded trade unwinding,” the team wrote.
The third is contagion, as one sell-off often sparks another.
“High-sigma events tend to cluster together, both within and across assets. We find that prior to a fragility shock, there tends to be a rise in the frequency of such shocks in other assets,” they wrote.
The global equity derivatives research team wrote that fragility could come roaring back in the fall as investors react to the possibility that the Fed will start reducing economic stimulus, combined with typical seasonal market behavior.
“Equities back at new highs will merely encourage more of the investor behavior that historically precedes larger fragility shocks,” they wrote. “We believe the US equity market is underpricing the risks of a looming tapering cycle. … The Fed’s outlook remains impaired by the extreme uncertainty in the macro forecasts on which they base their decisions.”
Since late 2019, the bank has recommended what it calls “the ‘W’ trade” as a way to affordably handle fragility. To apply it, an investor needs to set up offsetting trades by selling one short SPX put, three short puts, 1 long call, and 2 short calls.
“S&P fragility events have typically been more significant on the downside than the upside, hence the rationale for having one less (long) call,” BofA says, adding that if it had been applied over the past 19 years it would have had a positive return in addition to providing portfolio protection.
“The short SPX put ratios typically do the heavy lifting in shocks, benefiting from the realized fragility event but also from any resets higher in implied vol, skew, and/or convexity; while (ii) the short call ratios tend to act as the funding (i.e., positive carry) leg,” BofA said.
And the bank says there’s also a simple way to use options to book an extra profit around the fragility that could afflict the market this fall.
“To more safely position for further upside, we reiterate our preference for SPX calls funded by selling VIX puts,” the team wrote, explaining that call options on the S&P 500 remain extremely cheap. “We like selling the VIX Sep 17 put to fund the SPX Sep 4510 calls, strikes that options markets view as equally likely at expiry.”