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Investors are riding out the “whack-a-mole” software sell-off by loading up on protection against volatility and exploiting the divergence in sectors tipped to be either winners or losers from AI’s advance.
Some of Wall Street’s biggest players are turning to complex options and hedging strategies to navigate a market buffeted by blog posts and headlines that have recently wiped tens of billions of dollars off the value of some of the S&P 500’s largest tech groups.
On Monday, a 10,000-word Substack detailing a future in which AI hollows out consumption by raising unemployment sparked a fresh wave of selling across the software and private capital sectors.
Hours later, Anthropic said its new Claude Code AI tool could soon replace a widely used computer programming language. Shares in IBM promptly plunged 13 per cent, the company’s worst one-day decline in more than 25 years.
“For years and years everything moved in lockstep. But recent moves have been very, very dramatic in both directions,” said Charles Lemonides, the founder of hedge fund ValueWorks. “The swings are just crazy.”
Confronted with such febrile markets, stockpicking has become a matter of “avoiding implosions”, said Mike O’Rourke at Jones Trading.
Investors are embracing so-called dispersion trades, which involve buying single-stock volatility while selling index volatility to profit from the gap between the S&P 500’s relatively subdued daily moves and large price swings for individual companies.
The S&P 500 has added just 1.5 per cent and traded within a 2.7 per cent range since the start of the year, “the tightest in a century outside 1964 and 1966”, according to Barclays analysts. But “this calm at the macro level masks wild gyrations at the micro level”, they added.
The gap between individual stock moves and the relative stability of the S&P is at its widest since the global financial crisis in 2009, Citadel Securities said last week.
“The pure dollar number which is chasing [the dispersion trade] is bigger than before,” said Anshul Gupta, head of quantitative investment strategies at Barclays.
“The fast money accounts like hedge funds are much more active . . . But you’re also seeing the application of this [trading strategy] going way beyond just the hedge funds,” with asset managers and pension funds increasingly active, he added.
Jason Goldberg, a senior portfolio manager at Capstone Investment Advisors, who specialises in dispersion trades, said the ratio of short-dated stock option prices to index option prices has risen sharply. “The options market is telling you it expects a high dispersion environment,” he added.
Manish Kabra, head of US equity strategy at Société Générale, said wealth manager clients had been inquiring about dispersion products to allow them to trade the split in the tech sector between the perceived winners and losers from AI disruption.
“Someone is going to win, we don’t know who, but we want to play the absolute dispersion,” Kabra said.
Other investors are seeking ways to protect their portfolios amid the market churn.
Charlie McElligott, managing director of global equity derivatives at Nomura, said “institutional client hedging has been relentless” in response to “the deluge of negative catalysts for equities” and the ongoing “game of market doom whack-a-mole”.
Nomura clients have accelerated their purchases of puts on Invesco’s Senior Loan exchange traded fund and the iShares High Yield Corporate Bond ETF, both of which include several software companies among their top holdings, McElligott said.
In a note to clients this week, JPMorgan touted its so-called “Triple Edge hedging framework” to investors searching for a “disciplined way to manage episodic pullbacks”.
When measures of market volatility rise, the bank suggests buying “convex” short-dated S&P 500 puts that quickly become more expensive during sudden and severe sell-offs. The strategy “shifts toward more cost-efficient pay-offs during calmer periods”, the bank said.
Lisa Shalett, head of the global investment office at Morgan Stanley Wealth Management, noted that traders meanwhile appear to be shorting consumer discretionary stocks while going long on industrials — a “pair trade” inspired by nascent signs of weakening consumption and bets on stocks likely to benefit from the infrastructure build-out required to power large language models.
Dispersion trades could come unstuck if markets suffer a broader setback — perhaps sparked by geopolitical risks or an escalation of trade wars — that causes stocks to fall in unison.
In that situation, investors who have bet on dispersion might be forced to buy index-level volatility protection, potentially exacerbating a market wide sell-off, according to Jasmine Yeo, a fund manager at Ruffer.
