Wall Street seems calm. A closer look reveals something different.

In the stock market, not everything is as it seems.

A slowing inflation rate has boosted investor confidence in the economy this year and, combined with intense interest in artificial intelligence, has created the backdrop for a rally that has exceeded expectations.

The S&P 500 rose about 15 percent in the first half of 2024, hitting a record high.

Gains were remarkably steady, with the index rising or falling by more than 2 percent in a single day only once. (It rose.) A widely held gauge for bets on coming volatility is near all-time lows.

But a look beneath the surface reveals much greater turbulence. Nvidia, for example, whose soaring stock price helped it become the most valuable public company in America last week, has risen more than 150 percent this year. The price is Shares have also fallen sharply over the past six months, each time losing billions of dollars in market value.

More than 200 companies, or roughly 40 percent of the index’s stocks, are at least 10 percent below their highs for the year. Nearly 300 companies, or roughly 60 percent of the index, are more than 10 percent above their lows for the year. And each group includes 65 companies that have actually moved both ways.

Traders say this lack of correlated movement – ​​known as dispersion – between individual stocks is at historic extremes, undermining the idea that markets have been blanketed by calm.

A measure of this, an index from stock market operator Cboe Global Markets, shows dispersion increased after the coronavirus pandemic, as tech stocks soared while shares of other companies fell. It has remained high, in part because of the stunning valuation of a select number of stocks at the cutting edge of AI, analysts say.

This presents an opportunity for Wall Street as mutual funds and trading firms flock to dispersion trading. This is a strategy that typically uses derivatives to bet on index volatility remaining low while individual stock turbulence remains high.

“It’s everywhere,” says Stephen Crewe, a longtime dispersion trader and partner at Fulcrum Asset Management. He believes that these dynamics have surpassed even the most highly anticipated economic data in terms of their importance for financial markets. “It makes virtually no difference at this point in terms of GDP or inflation,” he added.

The risk for investors is that stocks will start moving in the same direction again, all at once – most likely due to a spark that ignites widespread selling. Some fear that if that happens, the role of complex volatility trades will reverse and worsen the appearance of turbulence rather than dampening it.

The spread trade.

Estimating the total size of this type of trading is a challenge, even for those who are embedded in the market, partly because there are multiple ways to place such a bet. Even in its most basic form, dispersion trading can involve several financial products that are bought and sold for multiple other reasons.

How big is it? “That’s a million-dollar question,” Mr. Crewe said.

But there are some clues. The options market has grown enormously — the number of contracts traded is expected to top 12 billion this year, according to Cboe, up from 7.5 billion in 2020 — and while there have always been specialists with oddball derivatives strategies, more mainstream fund managers are now reportedly getting in on the act.

Assets in mutual funds and exchange-traded funds that trade options, including trade spreads, have risen to more than $80 billion this year, from about $20 billion at the end of 2019, according to Morningstar Direct. And bankers who offer clients a way to simulate sophisticated trades, but without the specialist knowledge, say they have seen a groundswell of interest in spread trading.

While its magnitude cannot be fully assessed, this observed influx of funds raises comparisons to the last time volatility trading became popular, in the years leading up to 2018.

At the time, investors had flocked to options, turning to exchange-traded products that delivered big returns in muted markets but were highly sensitive to sharp selling that increased volatility. These trades were explicitly ‘short volatility’, meaning they profited when volatility fell, but lost heavily when the market became turbulent.

So when markets suddenly broke out in February 2018 and the S&P 500 fell 4.1 percent in a single day, some funds were wiped out.

While this dynamic remains, analysts say it is much less significant and the rise of popular diversification strategies is fundamentally different.

Because trading attempts to profit from the difference between low index volatility and significant swings in individual stocks, even in a severe sell-off the outcome is typically more balanced, with one part likely to rise in value while the other part falls in value.

But even this generalization depends on how the trade is executed, and there are circumstances that can still get investors into trouble. That potential outcome is one of the reasons dispersion trading is getting so much attention right now — everything could go well, but it’s very hard to know for sure, and what if it doesn’t?

“The firewood is very, very dry,” said Matt Smith, fund manager at Ruffer, a London-based asset manager. “And there’s a lot going on in the world, so the weather is warm.”

The unwinding can be ugly.

Crucially, even the market’s biggest companies are dispersed. Microsoft, a beneficiary of AI enthusiasm, is up 20 percent this year. Tesla is down 20 percent. Nvidia remains the outlier, with dizzying gains.

So even on a day like Monday, when Nvidia fell 6.7 percent, the S&P 500 fell only 0.3 percent. The broad index was supported by other stocks, especially other giant tech companies such as Microsoft and Alphabet.

There seemed to be calm, despite the sharp decline in one of the index’s largest components.

If the very large stocks start falling all at once, as they will in 2022, the outcome could be painful. Dispersion trading can make things worse.

If S&P 500 volatility is sent higher by a stock like Nvidia plummeting, but the damage is contained to tech- or AI-specific sectors, an asymmetric outcome would punish many spread trades, industry experts say. Losses could mount as traders looking to limit their losses execute trades that exacerbate volatility.

This possibility is hypothetical. Nvidia has yet to meet demand for its chips and its profits continue to soar. The spread could continue for a while given these unusual market dynamics, bankers and traders said.

But for some specialist investors who are more experienced with the complexities of trading diversification, trading has lost its luster as it has been pushed to increasingly extreme levels.

Naren Karanam, one of the market’s biggest spread traders who plies his trade at hedge fund Millennium Management, has scaled back his operations and sees fewer opportunities for profit, say people with knowledge of his decision. A rival hedge fund, Citadel, lost its chief spread trader in January and opted not to replace the person.

Even some who remain in the market say that the extreme current dynamics, with such low volatility at the index level and such high dispersion of individual stocks, give them little incentive to increase their trading. Others have gone the other way, hedging against a tumultuous sell-off.

“Diversification can’t get much higher, and volatility can’t get much lower,” said Henry Schwartz, Global Head of Client Engagement at Cboe. “There is a limit.”