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Could there be a bubble in correlation?
And by that rationale could it be time to position against a bursting of that bubble?
Those, at least, are the thoughts of JP Morgan’s global equity derivatives and delta one strategy team, led by Marko Kolanovic, in their latest note. It’s rather aptly entitled; “Why we have a correlation bubble”.
(H/T Joe Saluzzi at Themis Trading.)
Here’s their thinking:
1) Correlations between stocks are at their highest levels in recent history.
2) The option-implied price of correlation is even higher — a result of an inadequate supply of index put options and oversupply of stock options via overwriting.
Consequently:
We conclude that both the realized correlation of stock prices and option implied correlation are in a "?bubble' regime and forecast a significant decline of correlation over a one- to two-year time horizon.
Increased correlation itself, they say, is down in part to the the macro-driven environment but also (surprise, surprise) to the record use of index derivatives such as futures and also, although to a lesser extent, ETFs and high-frequency trading.
With regards to the index futures and ETF effect, they explain:
We believe that the excess levels of correlation are related to the increased usage of index-based products, in particular futures and some broad-index ETFs.
When investors trade an S&P 500 futures contract, they effectively place a simultaneous order for the 500 constituent stocks (e.g., buying a future will cause incremental upward pressure for all 500 stocks, and selling a future will cause an incremental downward pressure for all 500 stocks).
It is easy to see that if investors only traded futures (e.g., futures were 100% of all equity volumes) the correlation of stocks would be 100%. For this reason, it is reasonable to expect that market correlations should be proportional to the prevalence of index products relative to stock volumes. Broad-index ETFs (such as S&P 500 ETFs) have a similar effect on market correlation.
Meanwhile, the HFT impact, they say, is likely connected to the strong preference of index arbitrage strategies by such traders:
It is estimated that currently close to 60% of U.S. turnover by volume is due to HFT (in Europe, it is estimated that ~38% of trading volume is due to HFT). It is reasonable to expect that such magnitude of trading activity will significantly change the market microstructure.
—–
Current index volumes are significantly larger than total cash volumes, and a good amount of index derivative volume (Futures, ETFs) will not be directly offset by trades in cash securities. If the index price diverges from the prices of underlying constituents, index arbitrage HFT will act to realign them.
For instance, if a group of stocks outperforms the index, an arbitrage program may sell these stocks and buy the index, causing their prices to realign. This trading activity will dampen the volatility of stocks and increase their correlation to the rest of the stocks in the index. HFT index arbitrage also facilitates the transfer of the market impact on futures and ETFs to the underlying stocks, thus providing a link between the high percentage of index trading and correlation of individual stocks.
And also via general statistical arbitrage :
Another HFT trading strategy is a A simplified example is a pair trade between two correlated stocks. If the price of one stock increases relative to the other, an arbitrage program will sell the outperforming stock and buy the underperforming one, thus reducing the volatility of both and increasing the correlation between the two.
All of these mechanisms are largely self-reinforcing, say JPM. Nevertheless, many of the factors currently causing extreme levels of implied and realised correlation are bound to revert, they believe — especially if you look to historical precedent.
As they explain:
The current correlation environment is similar to that in the second quarter of 2003, when the market started recovering from the high macro-volatility period of 2001-2003. During the early stages of the 2003 recovery, implied correlation was still high and sharply declined over the next two years.
And based on that view they recommend selling one- to two-year implied correlation on the S&P 500 — largely because at current levels of about 80 per cent, implied correlation can’s really go much higher.
Or as they say, “it’s essentially a free call option on the market recovery.”
Of course, if correlations do stay high regardless — they concede that might mean the impact of index products and HFT on correlation has been greater than most have anticipated.
Full report in the usual place.
Related links High Frequency Trading and ETFs "“ FTfm Statistical arbitrage and the big retail ETF con-fusion - FT Alphaville Electronic trading and commodity prices "“ FT Alphaville
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