a complicated derivatives trade that may have helped power some of the us stock market’s postmarch rally is showing signs of unwinding with potential consequences for the broader market one veteran analyst warned tuesday should it come completely unglued the result could be nearly 500 points shaved off the sp 500 index a move that would erase much of this year’s nearly 18 gain factset data show in his latest missive to subscribers michael kramer founder of mott capital management and a longtime independent market analyst said he’s seeing signs that a complicated play known as the “short volatility dispersion” trade is starting to unravel threatening a rapid unwind if the past is any guide here’s how the trade works according to kramer traders purchase call options on big seven stocks like apple inc aapl  while at the same time selling call options on the sp 500 spx index to offset the cost of the individual stock options then they hedge their short position with shares in apple or other sp 500 components helping to limit their risk should the trade move against them a call option gives traders the right but not the obligation to buy shares in a given stock although index options are often settled in cash or in futures tied to the index kramer has been tracking the trade in his newsletter for months he believes sophisticated traders saw opportunity after the collapse of silicon valley bank when the cboe volatility index otherwise known as the vix traded as high as 30 intraday its highest level of 2023 those who put this trade on hoped the sp 500 would continue to rally sending the vix lower while traders would continue to pile into call options on the big seven stocks in a way the trade is also a bet that individual sp 500 components would outperform the index which has been a major theme for markets this year heading into the secondquarter earnings reporting season the trade worked well as the vix fell while the socalled “magnificent seven” stocks pushed the sp 500 higher this group includes apple inc aapl  microsoft corp msft  alphabet inc’s class a googl and class c goog shares meta platforms inc meta  amazoncom inc amzn  tesla inc tsla  nvidia corp nvda for months the vix continued to fall cheapening the price of sp 500 index options while heavy demand for options tied to the market leaders drove implied volatility on those individual stocks higher creating the volatilitydispersion effect from which the trade derives its name to see whether the trade is working traders could monitor the cboe’s onemonth implied correlation index which measures the difference between implied volatility for the sp 500 and individual stocks in the index the trade is working so long as the line in the chart above is declining but after falling to its lowest level since early 2018 in late july dispersion suddenly lessened over the past week as stocks like apple sank along with the broader market sending the vix back above 17 for the first time since late june factset data show “the important thing to remember is this is just an implied volatility trade what they’re trying to do is bet that volatility will mean revert which means fall from where it had been” kramer told marketwatch during a phone call “the person is selling index options and buying options on the index components that’s a bet that the implied volatility of the sp 500 is going to fall and by buying calls on the underlying stocks they’re hedging against longvolatility risks” kramer believes that during its heyday this trade helped to create a perpetual motion machine buying individual stocks and individual equity call options should push the sp 500 up and implied volatility on the index down inspiring more traders to pile in creating a cyclical effect that pushed stocks higher and printed profits until it didn’t now kramer sees risks that the trade could completely unwind financial conditions have begun to tighten again as the us dollar has strengthened while global bond yields have risen recently tighter financial conditions are typically associated with higher implied volatility for stocks as traders brace for blowback to equity valuations caused by more attractive yields on bonds along with the possibility that the real economy might suffer as corporations’ borrowing costs rise “for this trade to be profitable the implied volatility of the sp 500 needs to be moving in the opposite direction as the implied volatility on the individual stocks” kramer said “if you start to see the vix rise that’s a bad sign because it means that the trade is no longer working” while it’s not a perfect analogy kramer sees echoes of “volmageddon” when the vix doubled on feb 5 2018 as a popular shortvolatility trade unwound lashing stocks in the process on that day the dow jones industrial average djia recorded what was then its biggest daily point drop on record it’s just another example of how activity in equity derivatives markets can drive trading in the underlying assets “if this trade continues to unwind we could continue to see more downside in stocks” kramer added us stocks were falling again on tuesday with the sp 500 down 12 at 4466 while the vix shot up to 175 its highest level since may factset data show the nasdaq composite comp which is more heavily weighted to the magnificent seven fell even further down 14 at 13802