Rumbling in Options Market Is Sound of Traders Rushing to Hedge

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(Bloomberg) — The only thing that isn’t falling in markets is the price of protection — complicating the lives of harried traders rushing to hedge.

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The issue is particularly pronounced in equities, where the relative cost of loss-protecting put contracts is as high as its been any time in two years. The benchmark options index in the U.S., know as the VIX, on Monday briefly surged above longer-dated futures — a relatively rare inversion that occurs when market volatility mushrooms.

Higher insurance costs are another thing to worry about as the S&P 500 flirts with its lowest levels in almost a year. China’s Covid cases resurged, fueling recession angst at a time when the Federal Reserve is set to begin what will probably be the most aggressive rate-hike cycle since 1994.

“Earnings aren’t providing the relief some have been waiting for. At this point, the only thing working is hedging,” said Danny Kirsch, head of options at Piper Sandler & Co. “Due to this demand for downside, you’re seeing skew increase, VIX invert, put volumes explode — everything you’d expect in extreme riskoff.”

Volume in puts jumped, reaching the highest level versus calls since the pandemic crash in 2020. The hedges appeared to put a brake on the drop Monday at least, a session in which the S&P 500 was at one point headed for its first string of three straight 1%-plus drops in two years. Ballooning options positions have occasionally coincided with bottoms in the stock market over the past five years.

Equities started Monday in the red as fresh news that China expanded coronavirus testing to most of Beijing exacerbated concerns that the world’s economy may lose one of its biggest growth engines. The S&P 500 dropped as much as 1.7% before erasing losses to end the day higher. Oil slipped and Treasury yields halted a relentless surge in 2022 as investors sought safety in government bonds.

The Cboe Volatility Index, a guage of cost of S&P 500 options, jumped as high as 31.60 before retreating. For most of Monday, the VIX stayed above its three-month futures. A pattern that typically forms during times of stress, the VIX curve inversion has occurred only a handful times during the past two years.

“The worry is quickly moving away from inflation to hard China landing scenario. Or China does a March 2020-type move and just shuts everything down,” said Dennis DeBusschere, the founder of 22V Research. “That is obviously a major headwind for rates and oil, and a headwind for equities as a hard China landing would not be a positive.”

The cost of hedging also rose. Take the skew of SPDR S&P 500 ETF Trust (ticker SPY), the largest exchange-traded fund. On Friday, the implied volatility of one-month puts betting on a 10% decline stood 18 points above calls wagering on a 10% gain over a comparable period. Only 18% of the time over the past two years has the market seen skew higher than that.

To contrarians, all the light positioning and negative sentiment set the stage for a rebound in the stock market. JPMorgan Chase & Co.’s Marko Kolanovic, who urged investors to take some profits on stocks earlier this month, says the market is likely to rally in the coming days, reversing losses from the previous week. Among buyers, he says, are companies emerging from a buyback blackout and funds shifting money from fixed income after April’s equity selloff to return to preset asset-allocation levels at the month-end.

“We see risks skewed toward a near-term equity rally given weak investor sentiment, low positioning, systematic strategy buying, seasonality, and oversold conditions,” Kolanovic wrote in a note Monday. “While we slightly reduced our record equity allocation, we remain constructive on equities.”

Jason Goepfert at Sundial Capital Research is less sanguine. While sentiment has worsened, it has yet to reach capitulation to sound the all clear.

The Cboe put/call ratio “also spiked in January and only led to a brief reprieve before stocks fell to lower lows,” Goepfert said. Most sentiment indicators “are not yet showing extreme pessimism, though. Anxiety? Sure. Panic? Nope.”

The options data is the latest evidence of souring sentiment in the stock market. ETF investors, one of the staunchest bulls in 2022, are abandoning their dip-buying strategy. For three straight weeks, they dumped stocks — a stretch of persistent disposals not seen since August 2019, data compiled by Bloomberg show.

For those sticking around, defensive shares are preferred, with consumer staples beating all other major industries this month.

Technical factors aside, a lingering trouble for bulls is that their long-held mantra — “there is no alternative” for stocks — is under threat. The asset’s valuation edge in quickly shrinking relative to bonds, with the Fed increasingly under pressure to hike rates and tame inflation.

Outside a brief period in early 2021, the S&P 500’s earnings yield — a reciprocal of price-earnings that measures how much investors get for holding stocks — sat at levels not seen since 2010.

Many view equities as a hedge against inflation in part because corporate earnings can benefit as long as higher costs are passed on to consumers. Yet from a valuation perspective, equities are becoming less appealing next to red-hot inflation. The S&P 500’s real earnings yield, one that strips out inflation, has turned negative for the first time in two decades — hitting the lowest level since at least the 1950s.

To Lisa Shalett, chief investment officer of Morgan Stanley Wealth Management, the Fed’s monetary tightening has emboldened a stronger dollar that is set to hurt earnings of many American multinational firms. That, along with an ominous valuation backdrop, suggests more pain is in store for investors, she says.

“Valuations are rich while growth is decelerating, policy is tightening, the dollar is climbing and execution risk is extreme,” Shalett wrote in a note Monday. “In our view, the bear market is not over.”

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