Explained: How a massive options trade by a JP Morgan fund can move the markets

A Wall Street branding sign outside the New York Stock Exchange (NYSE) in New York, where markets crashed after Russia continues to attack Ukraine, in New York, United States, February 24, 2022. REUTERS/Caitlin Ochs

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NEW YORK, June 28 (Reuters) – A nearly $17 billion JP Morgan fund is expected to reset its options positions on Thursday, which could increase stock volatility at the end of a dismal first half for stocks.

Analysts say the JPMorgan Hedged Equity Fund reset rocked markets in the final hours of last quarter and has the potential to move markets again this time around. Read more

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WHAT IS THE JP MORGAN HEDGED EQUITY FUND?

The JPMorgan Hedged Equity Fund holds a basket of S&P 500 (.SPX) stocks as well as options on the benchmark and resets the hedges quarterly. The fund, which held about $16.71 billion in assets as of June 27, aims to allow investors to benefit from stock market gains while limiting their exposure to equity declines.

For the year, the fund was down 9.6% through June 27, compared to a 17.6% decline for the S&P 500 Total Return Index (.SPXTR).

Its assets have exploded in recent years as investors seek protection from the kind of wild swings that rocked markets in the wake of the COVID-19 outbreak in March 2020.

The fund’s holdings include some of the biggest names in the market, such as shares of Apple Inc (AAPL.O), Microsoft Corp (MSFT.O) and Amazon.com Inc (AMZN.O).

HOW DOES THE FUND USE OPTIONS?

The fund uses an option overlay strategy that involves buying put options that pay out if the S&P 500 declines about 5% or more from its level at the start of each quarter. To limit the cost of these put option purchases, the fund also sells put options that would make money if the S&P 500 lost more than 20%.

In addition, the fund writes call options entered into at approximately 3.5% to 5.5% above the market level, to help fund the cost of hedging.

In total, the trade is structured in such a way that investors are protected if the market drops -5% to -20%, and they are able to take advantage of any market gains within an average range of 3.5 to 5.5%.

In March, the discounting of these positions involved about 130,000 S&P 500 contracts in total, worth about $20 billion in notional terms.

HOW CAN THIS AFFECT THE WIDER MARKET?

Options brokers – usually large financial institutions that facilitate trades but seek to remain market neutral – take the other side of the fund’s option trades.

To minimize their own risk, they usually buy or sell stock futures, depending on the direction of the market move. Such trading related to dealer coverage has the potential to influence the broader market, especially if done in size, as is the case with JPM trading.

The S&P 500 Index (.SPX) fell 1.2% in the last hour of trading on March 31 amid no obvious news – a move some analysts have pinned on options hedging flows. Read more

Traders say the discount could exacerbate market swings on Thursday, as the fund rolls over options positions and dealers buy and sell futures to hedge their exposure.

Charlie McElligott, equity derivatives strategist at Nomura, believes that all things being equal, more volatility and equity weakness could follow after June 30, once the trade is complete.

The strategy’s put options corresponding to the 3,620 level on the S&P 500, the lower leg of the trade, may have supported the market during its fall this month, he said.

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Reporting by Saqib Iqbal Ahmed in New York Editing by Ira Iosebashvili and Matthew Lewis

Our standards: The Thomson Reuters Trust Principles.

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