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A closely-watched gauge of stock market sentiment has hit its most extreme level since 2008, as options traders increasingly focus on capturing further gains in soaring indices rather than worrying about a potential sell-off.
An almost 25 per cent rise for Wall Street’s benchmark S&P 500 index since the start of November has wrongfooted traders who had expected high interest rates to trigger a recession.
Many are now snapping up options tied to the S&P that profit if the market keeps on rising. At the same time, the strength of the rally, which has come in spite of higher than forecast inflation in January and February, has meant that investors have largely opted against purchasing options that protect them against market falls.
Options are a type of derivative that confer the right but not the obligation to buy an underlying asset at a certain price — a call — or sell an asset at a pre-agreed price — a put.
Usually calls are cheaper to purchase than puts, reflecting investors’ typical preference for buying stocks and then hedging their portfolio with puts.
However, puts that guard against less than 10 per cent index declines have become so cheap off the back of the US market’s barnstorming rally that the two-month so-called skew — a measure of the difference between the implied volatility of puts relative to calls — for both the S&P and the tech-heavy Nasdaq Composite has fallen to the lowest levels in 16 years, according to Bloomberg data gathered by UBS. Implied volatility reflects the market’s forecast of moves in a security’s price over a fixed period of time.
“There’s been a lot of Fear of Missing Out, partly because it’s been a very strong rally, so the hedge for a lot of people is to make sure they’ve covered that upside,” said Gerry Fowler, an equities and derivatives strategist at UBS.
“No one is really worried about small downturns, so no one is bothering to buy the puts,” he added.
Such a narrow price gap between puts and calls — a “flat skew” in industry jargon — is unusual during aggressive market rallies, when investors generally take out insurance against potential pullbacks.
“Normally when you have markets at all-time highs people start getting a little bit worried and bidding up the puts relative to calls,” said Rocky Fishman, a derivatives analyst at research group Asym 500. “But that’s not always the case — it certainly was not the case around the dotcom bubble.”
Other said that pricing in the options market this year underscores investors’ confidence that the US economy is heading for a so-called soft landing rather than a recession.
Flat skew at the top of a market rally “can speak to nervousness about valuations, that investors are getting uncomfortable. Or it could be rally-chasing, a sign that investors think there’s more to come,” Fishman added.
Investors are so bullish that “fear of a crash-up” now trumps “any meaningful concern of a correction lower,” said Charlie McElligott, managing director of cross-asset strategy at Nomura, who wrote in a note to clients this week that markets “are foaming at the mouth”.
Speculative assets have become increasingly popular as investors’ appetite for risk has returned.
Surging demand for bullish options tied to US meme stocks including broker Robinhood, car seller Carvana and cryptocurrency exchange Coinbase means the implied volatility of calls now exceeds the implied volatility of puts for all three securities, according to Nomura — an inversion of the ordinary relationship. The same is also true for Nvidia.
But despite their faith in the ongoing rally, investors have not entirely done away with insuring themselves against a crash.
“People are fine with 5 to 10 per cent [market] declines. What they’re hedging is the much larger moves, and they’re doing that by using out-of-the-money VIX options,” Fowler said, referring to derivatives that would pay out if Wall Street’s “fear gauge” were to jump following an economic or geopolitical Black Swan event.
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