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 – leading 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 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.