Analysis: Wall Street charges ahead but some option traders hedge against sharp pullback

NEW YORK (Reuters) – Even as US stocks climb record highs day in and day out and Wall Street’s “fear knife” shows little concern, some corners of the options market suggest that investors are far more afraid of a major pullback than they have been doing for months.

Known as Wall Street’s fear meter, the Cboe volatility index is back near its post-pandemic lows, showing that investors have little fear of short-term stock market weakness. But other, less obvious, measures are flashing red, suggesting concerns that the market could face a sharp decline.

For example, it is unusually expensive for investors to hedge their portfolios against a sharp fall in the S&P 500 than it is to buy options that would benefit from a big profit.

A put option that hedges against a 10% decline in the S&P 500 through August is about 35 times as expensive as a call option that would benefit from a 10% increase. At the height of the stock market panic in March 2020, that downside put option was only trading up to 11 times the upside calls, said Amy Wu Silverman, equity derivatives strategist at RBC Capital Markets.

Nations TailDex, which measures the cost of hedging against a 3-standard deviation of the SPDR S&P 500 ETF Trust, is higher than it has been about 90% of the time over the past five years.

That kind of contrast between the VIX and other actions “isn’t all that common,” said Randy Frederick, vice president of trading and derivatives at Charles Schwab.

A statement suggests that institutional investors – whom Frederick said were more likely to hedge against a major market decline – are acting to protect their downside, while retail investors continue to bet the market to get higher.

Joe Tigay, portfolio manager at Equity Armor Investments, believes the mixed signals from the market regarding volatility mean investors could hide at the first sign of trouble.

“I don’t think the market is as hedged as it should be,” said Tigay.

Some investors are nervous about the economic impact of the spread of the delta coronavirus variant and worry about how the Federal Reserve will react to inflation and economic growth data Arnim Holzer, macro and correlation defense strategist at EAB Investment Group.

Many investors are also unsettled due to the unusually long trading downtime.

Since World War II, the S&P 500 index has fallen at least 5% on average every 178 calendar days, according to Sam Stovall, chief investment strategist at CFRA. The most recent market surge lasted 292 days without such a decline, the longest period since January 2018 when a 715-day surge was followed by a 10.8% decline for the S&P 500.

Seasonality also plays a role. Mid-July through October has traditionally been the worst time of the year for stocks, according to Jeffrey Hirsch, editor of the Stock Trader’s Almanac.

“US stocks have been incredibly resilient,” said Chris Murphy, co-head of derivatives strategy at Susquehanna Investment Group, in a recent announcement to investors. “But with a seasonally weak period approaching and pre-earnings expectations skyrocketing, macro hedges are worth looking at.”

Reporting by Saqib Iqbal Ahmed; Editing by David Gregorio

source https://thedailytradingnews.com/analysis-wall-street-charges-ahead-but-some-option-traders-hedge-against-sharp-pullback/