Traders pile into bets that stock rally will continue

Tax cuts, robust U.S. economy boosted corporate profits in three months through June

With U.S. stock benchmarks mere points away from fresh records, some traders are piling into bets that share prices will rally higher and volatility will remain muted.

The S&P 500 and the technology-heavy Nasdaq Composite hit their second-highest close in history on Tuesday.

Options investors and traders are wagering the gains will continue. They have been scooping up bullish call options on the S&P 500, contracts that would pay out if the stock index took another leg higher, according to Credit Suisse. Call options give the right to buy shares at a later time if they hit a designated price.

An options measure known as skew on the S&P 500 has also fallen, according to Credit Suisse. Skew tracks the cost of bearish options versus bullish ones. When skew falls, it means bearish contracts are getting relatively cheaper.

In other words, traders in recent days have been shelling out for bullish options rather than bearish ones.

Meanwhile, skew remains elevated for exchange-traded funds like the tech-heavy In- vesco QQQ Trust and iShares Russell 2000 ETF, known as IWM, according to a Credit Suisse memo Monday. This signals there is still some fear lurking in the market over tech and small-cap stocks—groups that have been outperformers in the stock market this year.

The recent activity marks a reversion to an environment that dominated much of the past year and the early part of this year.

Investors abandoned more defensive options positions and hedges and favored bullish options, fearful of missing out on a potential rally. A volatility shock struck markets in February, causing a pause to this trend. Now, “both the macro and earnings backdrop set up well for [the S&P 500] to grind higher in the near term,” wrote Mandy Xu, derivatives strategist at Credit Suisse, in a note this week.

The majority of U.S. companies that have reported earnings have beat revenue and earnings estimates, according to FactSet. Tax cuts and a robust U.S. economy boosted corporate profits in the three months through June. Employment figures have stayed strong.

Another bullish sign is in the futures markets.

So-called “short vol” bets—or wagers that market volatility will fall—by investors including hedge funds hit the highest level since November, according to Commodity Futures Trading Commission data as of last week.

A bearish bet on volatility is akin to a bullish bet on stocks, since market turbulence tends to fall as equities drift higher. Short bets on volatility outnumbered long bets by almost three to one, the CFTC data show.