Wall Street binges on volatility hedges as equities hit record highs
U.S. stocks at fresh records belie new warnings under the surface of Wall Street's volatility complex.
In the aftermath of last week's Federal Reserve meeting, options traders are bidding up the price of contracts that guard against market drops, fuelling a metric known as skew.
One such measure is trading near the highest in over a year, tracking the relative cost of hedging against a one standard-deviation drop in the S&P 500.
With a handful of monetary officials sounding hawkish while government bonds price in economic setbacks, money managers are diving into the derivatives markets to protect portfolios as risk assets sit at historic valuations.
Another good reason for vigilance: Equities are enjoying the longest stretch of buoyancy since February 2018. It's a winning streak that could be broken by diminished liquidity during this time of year — or any surprises at the Jackson Hole summit of policy-makers in August.
“In one word, the market is fragile,” said Neil Patel of Optiver, an algorithmic trading firm that hosted a volatility webinar on Wednesday. “Not necessarily in this sense that there's going to be a rug pulled from underneath us, but fragile in the sense that there's a high demand for protection. A lot more skepticism than normal.”
One theory holds that in a world where Treasuries struggle to hedge stock drawdowns, buying equity volatility is more appealing than ever. The co-movement between bonds and stocks hit the highest since 1999 last month — a failure of diversification that increases the allure of alternative hedging strategies.
“There's probably a shift from bonds as protection to puts or volatility in general,” El Mehdi Benhmade, portfolio manager at Eisler Capital in London, said at the webinar.
The term structure of S&P options is also steep — indicating stiff demand for protection several months into the future, according to Benhmade.
The depletion of stock-market liquidity is another cause for worry, according to Rishabh Bhandari, a senior portfolio manager at Capstone Investment Advisors, a Us$9-billion hedge fund. Bhandari points to the dramatic diminution in market depth for S&P 500 Index futures as the source of increasingly large moves up and down.
“We already live in a regime where liquidity is an issue,” Bhandari said in a Bloomberg TV interview on Friday. “Summers tend to be poorer in liquidity, and investors need to be cognizant of it and preparing ahead of it.”
Options skew roughly measures the cost of downside protection versus the price of speculative contracts. S&P 500 options that expire between one and six months from now are seeing “very high skews,” according to Optiver's Patel.
All this is making the other side of the volatility trade — selling protection — lucrative, according to specialists. The Cboe Volatility Index has shed some 10 points since the start of the year and, at 16, is trading below its long-term average.
“I think you're going to make money selling vol,” said Danny Scinto, a partner at hedge fund BFAM Partners (Hong Kong) Ltd on the Optiver webinar.