(Bloomberg) — An eventful week for the S&P 500 index has led long-term complacent traders to turn to hedges they've been ignoring for months.
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Demand for broad-based insurance fell to multi-year lows in the first quarter as U.S. stocks hit a series of new highs despite rising geopolitical tensions and uncertainty around interest rates. I felt depressed. That changed this week, with a growing desire to protect against recession through a variety of measures.
“People are starting to realize that we've managed to get through the first three months of this year in the face of rising rates and the possibility of a rate cut,” said trading director Joe Mazzola. Educated at Charles Schwab Company. “Sometimes something has to give.”
The CBOE Volatility Index, known as the VIX, closed at its highest since November on Thursday before falling 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 option prices, remains above its 200-day moving average.
Investors have been increasingly hedging since late March, with the cost of bearish three-month put options at the largest premium to bullish contracts since mid-January. These positions are in addition to an insurance policy that has received more attention this year: tail risk hedging, which protects against large crashes rather than small corrections.
Some investors also use spreads. Spreads offer less downside protection but cost much less than outright contracts. Susquehanna International Group pointed to recent put spreads to protect against drawdowns in the S&P 500, which is often used as a benchmark for the health of small-cap stocks, the tech-heavy Nasdaq 100 and the Russell 2000.
Stephen Soraka of Belmont Capital Group, which manages hedging strategies for wealth management firms and financial institutions, said more clients are looking to hedge their portfolios around both equity benchmarks and individual tech companies.
“That's the effect of pricing and the catch-up that we've had,” he said. According to Soraka, this demand makes sense. After the S&P 500's wild rise, investors may want to protect their winnings. “It's natural.”
These days, traders' fears center around a mass of unknowns, including geopolitical tensions, the upcoming US presidential election, first-quarter earnings reports, and, of course, central bank policy. That last wild card came to the forefront last week after Federal Reserve Chairman Jerome Powell said bankers were in no hurry to ease borrowing. The mood further deteriorated when Federal Reserve Chairman Neel Kashkari raised the possibility of no interest rate cuts in 2024.
A surge in put volume associated with the iShares iBoxx High Yield Corporate Bond ETF (ticker HYG) showed investors are bracing for another Fed disappointment. If the Fed's tightening policy lowers interest rates on interest-rate-sensitive funds, the hedges tied to the funds are likely to pay off.
“If you think about what's actually driving some of the macro volatility, it's interest rates,” said Alex Kosoglyadov, managing director of equity derivatives at Nomura Securities International. He pointed out that if the amount is less than that, it could cause stock price fluctuations. “The Fed risks causing the market to fall,” he said.
Option positioning reflects the stock market's preference for established megacap stocks over riskier stocks. Growth and quality exchange-traded funds saw large inflows throughout March, compared to modest inflows to value funds.
According to Rohan Reddy, director of research at Global X Management, the demand for protection ultimately comes down to trader expectations. As the consensus for a soft landing grows, unwelcome surprises can cause some anxiety in even the most fearless bull market.
“Of course, there's a real possibility that things could get worse, in which case there might be an even greater desire to protect,” Reddy said.
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