Explainer-How A Massive Options Trade By A JP Morgan Fund Can Move Markets

A nearly $16 billion JP Morgan fund is expected to reset its options positions on Friday, potentially adding to equity volatility at the end of a gloomy quarter for stocks.

Analysts have in the past pointed to the JPMorgan Hedged Equity Fund's quarterly reset roiling markets, and see it as a source of potential volatility during Friday's session.

WHAT IS THE JP MORGAN HEDGED EQUITY FUND?

The JPMorgan Hedged Equity Fund holds a basket of S&P 500 stocks along with options on the benchmark index and resets hedges once a quarter. The fund, which had about $15.59 billion in assets as of September 28, aims to let investors benefit from equity market gains while limiting their exposure to declines.

For the year, the fund was down 10.66% through September 28, compared with a 21% decline for the S&P 500 Total return Index.

The fund's assets ballooned in recent years, as investors sought protection from the sort of wild swings that rocked markets in the wake of the COVID-19 outbreak in March 2020.

Its holdings include some of the market's biggest names, such as Apple Inc, Microsoft Corp and Amazon.com Inc.

HOW DOES THE FUND USE OPTIONS?

The fund uses an options strategy that seeks to protect investors if the S&P 500 falls between 5% and 20%, while allowing them to take advantage of any market gains in the average range of 3.5-5.5%. On June 30, the refresh of the fund's options positions involved about 140,000 S&P 500 options contracts in all, including S&P 500 puts at strikes 3580 and 3020 and calls at 4005, all for the September 30 expiry.

HOW CAN THIS AFFECT THE BROADER MARKET?

Options dealers - typically big financial institutions that facilitate trading but seek to remain market-neutral - take the other side of the fund's options trades.

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

The trade is "well understood" and "mostly digested by the market," said Chris Murphy, co-head of derivatives strategy at Susquehanna International Group.

It has, however, exacerbated daily moves in the past, according to some analysts.

The S&P 500 Index fell 1.2% in the last hour of trading on March 31 amid a lack of any obvious news - a move some analysts pinned on options hedging flows.

Analysts say the refresh could exacerbate market swings on Friday, as the fund rolls over its options positions and dealers buy and sell futures to hedge their exposure.

"That's because there is a fair amount that has to be adjusted and hedged to roll the trade," said Brent Kochuba, founder of analytic service SpotGamma.

"I believe that the position is expanding volatility this week," Kochuba said.

All else being equal, once the options position is rolled forward three month out, their influence on current price swings should diminish, he said.