Equity Pros More Covered Than Ever In Record S&P Rally
Yet, in the world of stock options at least, there is strong evidence that the professional class is keeping their head in the market crash.
Large institutions are still paying a decent premium to hedge the S&P 500 compared to the benchmark’s quiet lately. The demand for protection is also intact at around the long-term average.
So even if the Cboe volatility index falls to around pre-pandemic levels, institutional managers still protect portfolios with protective derivatives, reducing the risk of equity divestment at the first sign of trouble.
“I feel pretty good,” said Michael Purves, Managing Director of Tallbacken Capital Advisors. “The put-call ratio on the S&P is going down, but it’s still quite high.”
Purves refers to the ratio of outstanding bearish to bullish options, which hovers above its five-year average. Meanwhile, the bias of the S&P 500 – which compares the cost of buying puts and calls – is still around this year’s median level, once you control overall volatility. This is a sign that the positioning is not too extreme, according to Hugo Bernaldo, trader at market maker Optiver in Amsterdam.
Still, a key market divergence captivated Wall Street this week, fueling debate over whether stock investors have lost any sense of reality. As Treasury volatility jumped on monetary uncertainty, the VIX has remained remarkably stable, widening the gap between the two as much as possible since the start of 2020.
But there are good reasons for the low volatility of stocks in the face of bond anxiety, at least for now.
There is still a constant demand for hedges among pension funds after the equity rally, according to Jitesh Kumar, derivatives strategist at Societe Generale SA. In his view, this suggests that the recent drop in the VIX has more to do with supply, as some investors are selling volatility for yield, a popular Wall Street trade in an era of low interest rates.
There are also fundamental reasons for the resilience of stocks. S&P 500 company profits have continued to rise throughout this earnings season, a sign that large companies have largely weathered the supply-side chaos. And while rising consumer prices can hurt both stocks and bonds, the former has pricing power and always offers a premium over sovereign yields.
“The larger participants on the long side will seek to offset inflation by buying stocks,” said Kris Sidial, co-investment director of the volatility hedge fund Ambrus Group. “There’s no other game in town where the rates are.”
Also, when yields have risen slightly in this market cycle, there have always been winners like cyclical stocks rather than losers like bond proxies. The resulting performance differential, or dispersion, has helped limit the index’s overall volatility, according to SocGen’s Kumar.
It’s a dynamic that many on Wall Street are betting will continue for the rest of the year.
That’s not to say the derivatives landscape is flickering. The futures curve has steepened further recently, with increasing premiums for contracts starting in January. This is a sign that the recent calm has not alleviated the nervousness of the stock market outlook next year.
For now though, single stock options are where the speculative mania is, thanks to the day-trading army making an offer to their favorite companies. Their frenzied activity pushed the five-day average ratio between puts to outstanding calls near the lowest since February in Cboe data. In Tesla’s case, five-day call volume has hit an all-time high – a frenzy that has contributed to the huge surge in action over the past two weeks.
But at least at the index level, options aren’t a warning sign with healthy sell demand.
“If you buy a ton of calls and they expire worthless, that’s bad, but it’s not a market issue – it just means a bunch of investors wasted money on the bonuses, ”Purves said of Tallbacken. “If you don’t buy a bunch of put options and the market becomes problematic, it becomes a problem.”