Stock pros are as hedged as ever under record-smashing S&P rally

With the S&P 500 notching a new record every day this week while YOLO traders snap up tech bets like it’s GameStop Corp. all over again, cries of complacency in the stock market are everywhere. 

Yet in the world of equity options at least, there’s strong evidence the professional class is keeping its head in the market melt-up.

Big institutions are still paying a decent premium to hedge the S&P 500 Index compared with how tranquil the benchmark has actually been lately. Demand for protection is also intact at around the long-term average.

So even as the Cboe Volatility Index falls to around pre-pandemic levels, institutional managers are still buffering portfolios with protective derivatives -- reducing the risk of stock divestments at the first sign of trouble.

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“I feel pretty good,” said Michael Purves, chief executive officer of Tallbacken Capital Advisors. “The put-call ratio on the S&P has been falling, but it’s still pretty elevated.” 

Purves is referring to the ratio of outstanding bearish to bullish options, which is hovering above its five-year average. Meanwhile the S&P 500 skew -- which compares the cost of buying puts and calls -- is still sitting around this year’s median level, once you control for overall volatility. That’s a sign positioning isn’t too extreme, according to Hugo Bernaldo, a trader at market maker Optiver in Amsterdam.  

Big Divide

Yet a key market divergence captivated Wall Street this week, fueling debate over whether stock investors have lost all sense of reality. As Treasury volatility jumped on monetary uncertainty, the VIX stayed conspicuously stable -- widening the gap between the two to the most since early 2020.

But there are good reasons for low equity volatility in the face of bond anxiety, at least for now. 

There’s still consistent demand for hedges among the likes of pension funds after the stock rally, according to Jitesh Kumar, a derivatives strategist at Societe Generale SA. In his view, that suggests the VIX’s drop of late has more to do with the supply-side as some investors sell volatility for yield, a popular Wall Street trade in the low interest-rate era.

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There are also fundamental reasons for stock resilience. Profits for S&P 500 companies have kept rising through this earnings season in a sign that big corporates have largely weathered the supply-side chaos. And while rising consumer prices can hurt both shares and bonds, the former has pricing power and still offers a premium versus sovereign yields. 

“Larger buy-side participants will look to offset inflation by buying equities,” said Kris Sidial, co-chief investment officer at volatility hedge fund Ambrus Group. “There is no other game in town with where rates are.”

Besides, when yields have edged up in this market cycle there have still been winners like cyclical equities over losers like bond proxies. The resulting gap in performance, or dispersion, has helped cap the overall volatility of the index, according to SocGen’s Kumar. 

It’s a dynamic many on Wall Street are betting will continue for the rest of the year.

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That’s not to say the derivatives landscape is flashing the all-clear. The curve in futures has recently steepened further, with rising premiums for contracts from January onwards. It’s a sign the recent calm hasn’t assuaged jitters over the stock outlook next year. 

For now though, single-stock options are where the speculative mania is at, thanks to the day-trading army bidding up their favorite companies. Their frenetic activity has pushed the five-day average ratio between outstanding puts and calls near the lowest since February in Cboe data. In the case of Tesla, five-day call volume has jumped to a record high -- a frenzy that’s contributed to the stock’s huge surge over the past two weeks. 

But at least at the index level, options aren’t flashing a warning sign with put demand healthy. 

“If you buy a ton of calls and they expire worthless, it’s bad, but it’s not a market issue -- it just means a bunch of investors wasted money on premiums,” said Tallbacken’s Purves.  “If you don’t buy a bunch of puts and the market gets problematic, that becomes an issue.”