Quantcast

Options Trading: Investors Are Ditching Hedges

Posted On January 11, 2018 12:27 pm
By:

With stocks hitting new highs nearly every day, and even the shallowest dips being bought up the very next day, it’s gotten to the point where investors are having a hard time even imagining a decline. And as the Wall Street Journal recently documented, that inability to think the market will do nothing but go up has led people to abandon defensive hedges, such as buying put options. Naturally, this shift has some powerful implications for options trading.

Investors with significant positions in stocks often look to offset that risk by buying put options on stocks or major stock indices, like the S&P 500. These options trading contracts are a form of insurance that pay out when stocks fall.

But with the Dow Jones Industrial Average breaking through 25000 for the first time, the Nasdaq Composite crossing 7,000 and with market volatility falling to near all-time lows, many investors have decided that spending money to hedge against big declines is a waste of money. While the Dow Industrials slipped 0.05% Monday, the S&P 500 and Nasdaq Composite closed again at records.

Stock pickers are already feeling squeezed by competition from lower-cost passive investments such as exchange-traded funds and worry that they can’t risk falling behind in a rally. Purchasing market protection through hedges eats into their returns.

“I haven’t seen hedging activity this light since the end of the financial crisis,” said Peter Cecchini, a New York-based chief market strategist at Cantor Fitzgerald. “It started in late 2016 and accelerated in the second half of the year.”

 

Others signs of skeptical investors acknowledging the pull of the powerful bull market have also cropped up in recent days.

Jeremy Grantham, a bearish investor at Boston money managers Grantham Mayo Van Otterloo & Co. with a history of spotting market tops, said last week that investors ought to brace for explosive short-term stock gains.

He dubbed this phase a “melt-up,” or climactic late-rally leg higher that might push prices up an additional 50% over the next six months to two years.

A University of Michigan survey in October showed that consumers saw a nearly 65% chance on average that the stock market would rise in the next 12 months, the highest share on record. That measure remained near record levels in the following months.

New data indicate that either demand for protection is low or investors are favoring bullish options on the S&P 500 instead. A measure called “skew,” gauging the cost of insuring against short-term stock declines, recently hit a one-year low, data from Credit Suisse Group AG show.

 

Bets by hedge funds against volatility—similar to a bullish wager on stocks—outnumber bets on rising volatility, recent Commodity Futures Trading Commission data show. At 12 of the biggest banks in the world, revenue in their equity-derivatives businesses that focus on listed options shrank during the first half of 2017.

The blue-chip gauge has gone 386 trading days without a selloff of 5%, its longest stretch since 1996, according to The Wall Street Journal’s Market Data Group.

By letting their hedges expire, investors would feel the full brunt of a market selloff. While that would intensify the pain for any individual trader, some analysts and brokers worry that the cumulative effect of more investors giving up their protective positions could itself become a source of volatility.

Many investors could rush to sell their positions and limit their losses during the next period of market weakness, exacerbating any plunge in prices.

“When the ultimate disruption occurs, the market is less prepared for it,” Dean Curnutt, chief executive at New York brokerage Macro Risk Advisors, said. “That becomes an amplifier of the risk.”

Hedging against an unexpected surge in market turbulence, meanwhile, was a money loser. The S&P 500 jumped 19% in 2017, and the Cboe Volatility Index, known as the VIX, had its quietest year in history. That meant investors who bought such options were often stuck with worthless contracts. It was “a really difficult year to be a hedger,” said Macro Risk Advisors’ Mr. Curnutt.

It wasn’t supposed to be this way. Heading into 2017, many investors and analysts anticipated a new regime of market volatility with the Federal Reserve accelerating its pace of interest-rate increases and signaling an end to the era of supereasy monetary policy that followed the 2008 financial crisis.

A wave of political uncertainty linked to U.S. tensions with North Korea and the new presidential administration also raised the prospect that market tumults could occur with greater frequency.

Instead, a calm not seen in decades permeated markets. One sign of that: the VIX, which tends to move in the opposite direction of stocks, closed below 10 more times last year than any others year in its history.

Minor spikes in the VIX did crop up, but the gauge remained entrenched below its historical average throughout 2017.

“The first four Fed hikes in a decade have failed to generate the revival of volatilities that many had expected at the end of last year,” wrote Marko Kolanovic, a quantitative and derivatives analyst at JPMorgan Chase & Co., in a December note.

Placid markets could continue into 2018, Bank of America Merrill Lynch wrote in a recent report. “The behavior of volatility has entirely changed since 2014,” because major central banks have kept interest rates near historic lows, analysts wrote.

It suggested that the VIX would be hard-pressed to return to its long-term average of 20 “in a low rates world.”

 Related: Here’s How Cash Can Be Useful in Your Portfolio

Tagged with:

About author

Steve Smith
Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

Related Articles

Leave a reply

Your email address will not be published. Required fields are marked *