A bumpy week for the S&P 500 index prompted long-complacent traders to look at hedges they had ignored for months.
Broad-market demand for insurance slumped to multi-year lows in the first quarter, as U.S. stocks made a series of new highs despite rising geopolitical tensions and interest rate uncertainty. This week that changed as the desire to protect against a recession increased through a variety of measures.
“People are starting to recognize that we’ve gone through these first three months of the year, all in the face of rising interest rates, in the face of the likelihood of cuts,” said Joe Mazzola, director of trading and education at Charles Schwab & Co. “Something has to give sooner or later.”
The Cboe volatility index, known as VIX, closed Thursday at its highest level since November, before tumbling on Friday as U.S. stocks rose. The index – a measure of the S&P 500’s 30-day implied volatility based on out-of-the-money options prices – is still holding above its 200-day moving average.
Since late March, investors have slowly taken hedging measures, pushing the cost of three-month bearish put options to the highest premium over bullish contracts since mid-January. Such positions were in addition to insurance that has received more attention this year: tail risk coverages that protect against a major crash, rather than a minor correction.
Some investors use spreads, which offer less protection against a recession but cost much less than outright contracts. Susquehanna International Group pointed to recent drawdown-ready put spreads in the S&P 500, the tech-heavy Nasdaq 100 and the Russell 2000, often seen as a bellwether of small-cap health.
Stephen Solaka of Belmont Capital Group, which manages hedging strategies for asset management firms and institutions, said more clients have requested portfolio hedges tied to both stock benchmarks and individual technology companies.
“That’s a function of pricing and the rush we’ve had,” he said. According to Solaka, the request makes sense: After the strong rally in the S&P 500 index, investors may want to protect their winnings. “It’s natural.”
These days, traders’ angst centers on a number of unknowns: geopolitical tensions, the upcoming U.S. presidential election, first-quarter earnings reports and, of course, central bank policy. This latest wild card came to the fore last week after Federal Reserve Chairman Jerome Powell said bankers should not rush to ease lending. The Fed’s Neel Kashkari further soured the mood when he raised the possibility of no rate cut in 2024.
A spike in put volume tied to the iShares iBoxx High Yield Corporate Bond ETF (ticker HYG) signaled that investors are bracing for another disappointment from the Fed. Hedging tied to the fund would likely pay off if in which the Fed’s restrictive policy would push the rate-sensitive fund downwards.
“If you think about what drove some of the real macroeconomic volatility, it was interest rates,” said Alex Kosoglyadov, managing director of equity derivatives at Nomura Securities International, noting that fewer cuts than markets expect could catalyze stock movements. “Fed risk could push market lower.”
Option positioning reflects stock market action, which has favored established megacaps over riskier stocks. Growth and quality ETFs attracted massive inflows compared to poor inflows from value funds in March.
The demand for protection comes down to traders’ expectations, according to Rohan Reddy, director of research at Global X Management. With the growing consensus in favor of a soft landing, unwanted surprises can generate some angst in even the most courageous bull markets.
“There is, of course, a real possibility that things could get difficult, in which case there might be more of a desire to protect,” Reddy said.