ARKK ETF: The Options Market Does Not Believe This Rally

Thesis

The ARK Innovation ETF (NYSEARCA:ARKK) is up more than 23% year to date, having seen one of its largest one-month rallies in its history:

The beginning of 2023 has seen unprofitable tech rally substantially on the back of short-covering flows. The more important question at present is around whether this is just another bear market rally, or the start of a more sustained bull market in beaten-down technology stocks. We are of the opinion that we are witnessing another bear market rally, and the article outlines how the options market confirms this view.

What is the options market telling us

Usually, when a new bull market is developing, investors try to capture the nascent upside via call options (either outright or with call spreads). This bids up call options volatility, and results in what is called a ‘volatility smile’:

A volatility smile is a common graph shape that results from plotting the strike price and implied volatility of a group of options with the same underlying asset and expiration date. The volatility smile is so named because it looks like a smiling mouth. Implied volatility rises when the underlying asset of an option is further out of the money (OTM), or in the money (ITM), compared to at the money (ATM).

And to follow the heavy finance paragraph above with a nice visual, let us look at a theoretical ‘volatility smile’:

So the ‘smile’ is created by higher volatility for out-of-the-money puts and out-of-the-money calls. However, do notice the symmetry in a volatility smile – the idea here is that, in a normal market, there will be equal demand for both puts and calls, hence the volatility will be symmetrical.

Now let us have a look at how the ARKK volatility smile looks like:

We do not see a smile here, just a downward-sloping line! Why is this the case? Think about volatility as an asset class – if there is demand for something, investors bid that up, so the price goes up. The graph above tells us that investors have shown significant demand for ARKK puts (hence have bid up the left side of the graph), while showing little demand for ARKK calls (hence the low implied vol on the right side of the graph).

In a nutshell, ARKK does not have a ‘volatility smile’ because investors are fervently buying puts here, not calls. The above graph is for March 17, 2023 options. The June 2023 volatility smile looks similar:

Again, we see an almost 14-point volatility differential here for June 2023 options. The start of a new bull market would have investors bid up the June calls volatility and exhibit an implied volatility level similar to the put side.

Short covering can drive spot prices for ARKK much higher than here. However, true bull markets in a security are usually marked by option positioning on the long side via calls and call spreads. That type of positioning results in a normalized ‘volatility smile’ for ARKK, which is not there yet. The short covering move might not yet be exhausted, but the options market is telling us this is not a sustainable, new bull rally.

Conclusion

ARKK has seen a furious rally to begin the year, being up more than 23%. With such a strong performance this year, questions are emerging on whether this is the start of a new bull market in beaten-down technology stocks, or just another bear market rally. When looking at the options skew for ARKK we do not notice a ‘volatility smile’, but a down-sloping line for both March and June expiries. For June, the differential between IV for puts and calls is as wide as 14 points. The reason for the lack of a ‘volatility smile’ is the bidding up of put options for ARKK by investors. This translates into the investor community foreseeing more downside in the name, hence hedging their positions or taking speculative short bets. The start of a new bull market would see a normalization of the ‘volatility smile’ as investors would start bidding up call options and call spreads. Unfortunately, ARKK is not out of the woods yet, and while spot prices might continue to rise due to short covering, the options market is telling us this is not a sustainable, new bull rally.