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Investing.com - A tactic to hedge investment positions and flows around trend-following funds have helped to amplify price movements in financial markets, according to analysts at UBS.
The benchmark S&P 500 has jumped by more than 15% so far this year, underpinned in large part by ongoing enthusiasm around artificial intelligence that has aided a recovery in the average following a tariff-fueled April swoon. Along with the S&P 500, the tech-heavy Nasdaq Composite and blue-chip Dow Jones Industrial Average all notched fresh record closing highs on Friday.
In a note to clients, the UBS analysts including Nicolas Le Roux and Bhanu Baweja argued that so-called "option delta hedging" has acted to amplify some of the recent movement in prices.
This options-based strategy, commonly employed by institutional investors, aims to reduce or eliminate the risks that go with price changes in underlying assets. It works by achieving a "delta-neutral" state, where a portfolio’s value would not change for small movements in an underlying asset’s price.
"When a trader sells an option and the underlying price converges to the option strike, the option seller is constrained to readjust his/her risk by either buying back the option, which is costly, or by buying/selling the underlying. He/she usually opts for the second alternative, meaning he/she will be buying an asset as it rallies, or selling it as it sells-off, i.e. amplifying the recent price action," the analysts wrote.
Meanwhile, another factoring playing into price movements has been flows around "commodity trading advisors," or CTAs, a type of hedge fund which uses sophisticated computer algorithms to identify trends in asset prices. In the process, CTAs attempt to benefit from a persistence in asset returns, the UBS analysts said.
"Given their size and high trading activity, it has become harder to ignore their market impact and everyone is trying to assess their positioning and their potential flows," the brokerage added.
With short-dated options and CTA positioning in mind, the analysts recommended that investors keep tabs on levels of the Nasdaq index in particular.
They flagged that "lots of short-term gamma" on the Nasdaq has been bought as investors appear to be cautiously eyeing the current quarterly earnings season. The gamma buying could indicate that investors are betting on potentially large price moves in an underlying asset.
CTAs are also "max long" the Nasdaq, the analysts said. The trade is deeply "in the money," meaning an option’s strike price is more favorable than its current market price, so there will likely need to be a "decent sell-off" in the Nasdaq of roughly 5% from current levels before the CTAs start cutting their long positions, they added.