Geopolitical Tensions Leave Option Traders in Dilemma as Stock Market Reacts Subdued

Option traders are currently facing a dilemma due to the stock market's subdued reaction to escalating geopolitical threats. The recent escalation in tensions has left traders in a difficult position: they can either sell volatility and risk being caught off guard by a sudden escalation in the Middle East conflict, or buy volatility and watch their premiums erode if actual volatility remains low. This dilemma has been exacerbated by the recent U.S. strike on Iranian nuclear facilities.

While the oil market is expected to react more dramatically to any escalation in conflict, the stock market's volatility may see an initial spike as traders attempt to digest the associated risks. Since Israel's airstrike on Iran over a week ago, oil prices have surged by 11%, and oil volatility has reached its highest level since Russia's invasion of Ukraine in 2022. In contrast, the S&P 500 index has only declined by 1.3%.

Some traders may have become desensitized to the unpredictability of Donald Trump's policies or simply grown tired of chasing headlines. Over the past six months, the market has shifted from a "buy America" to a "sell America" stance and back to a more ambiguous state. Traders have learned to quickly rebound when risks subside, and the latest surge in oil prices could trigger a similar response, as it may lead to sustained U.S. inflation and slow down the Federal Reserve's rate-cutting pace.

This is the predicament faced by volatility traders such as the founder and CEO of investment firm IUR Capital. Selling volatility at current levels inherently carries the risk of a volatility event, while paying premiums for expected volatility increases means holding a continuously depreciating asset. For the options market, this environment has created uncertainty. On one hand, implied volatility has significantly decreased from its peak two months ago. On the other hand, premiums are not cheap, as the collapse in actual volatility of major stock indices makes them appear expensive.

As of last Friday, the CBOE Volatility Index (VIX) relative to the actual volatility of the S&P 500 index was near its highest level since April. While the options market may have underpriced volatility ahead of the July 9th expiration, leading to profitable volatility structures during the "gamma shock," the current environment is different. With the July 9th expiration date approaching, some strategists suggest that long-term gamma exposure is unlikely to yield the same profits as in April.

On a more tactical level, opportunities in repurchase agreements, correlations, and volatility are generally lacking, with no historical mispricings currently present. This is part of a broader, long-term trend, particularly in the retail structured products sector, which has traditionally been a major supplier of derivative risks. Some buyers are using stock replacement strategies to maintain their views while reducing risk, such as purchasing a basket of large-cap U.S. stocks' 2027 call options for a premium of up to 3 billion dollars.

Despite the muted market reaction, there are signs of increased caution among stock market traders. The Cboe VVIX Index, which measures VIX volatility, has risen to the higher end of its range over the past year, indicating that more people are interested in buying options to protect their portfolios from sharp fluctuations. This conflict and the stock market's subdued response have pushed the implied volatility of U.S. oil funds relative to the SPDR S&P 500 ETF to its highest level since the early days of the COVID-19 pandemic in 2020, prompting banks to offer more oil and stock dual binary hybrid trades.

In such a geopolitical and macro environment, hybrid products have naturally become a tool, with recent oil-themed activities linked to stocks (and foreign exchange) through directional and volatility trading. Some buyers are using stock replacement strategies to maintain their views while reducing risk, such as purchasing a basket of large-cap U.S. stocks' 2027 call options for a premium of up to 3 billion dollars. Despite the muted market reaction, there are signs of increased caution among stock market traders. The Cboe VVIX Index, which measures VIX volatility, has risen to the higher end of its range over the past year, indicating that more people are interested in buying options to protect their portfolios from sharp fluctuations. This conflict and the stock market's subdued response have pushed the implied volatility of U.S. oil funds relative to the SPDR S&P 500 ETF to its highest level since the early days of the COVID-19 pandemic in 2020, prompting banks to offer more oil and stock dual binary hybrid trades.