Stock traders eye Fed hedge for rally with call options

(Bloomberg) – Investors are stocking up on call options as they prepare for a crucial Federal Reserve decision that is set to dictate the tone of stocks heading into the second half of 2023.

Bloomberg’s Most Read

Options trading on U.S. exchanges at one point last week showed the largest bias in favor of calls in 14 months, according to data compiled by Bloomberg. Using calls allows investors to capture the upside if the bull market proves resilient, while remaining defensive as they are wary of what the Fed might signal this week about its policy trajectory.

The central bank is expected to pause tightening on Wednesday for the first time in 15 months. The risk, however, is that a resilient economy will keep the inflation rate stubbornly high, prompting officials to rise again as early as next month or keep borrowing costs high for longer. That could weigh on rate-sensitive Big Tech stocks that have been key to the market’s gains.

All of this makes this move by the Fed and subsequent remarks by Chairman Jerome Powell critical as investors’ stance for the rest of the year. Tuesday’s consumer price index reading also takes on added significance as signs of lower inflation could support equities, including areas like banks and small caps which are closely linked. to the health of the economy.

“There will always be a wall of worry, but the stock market is historically seeing better times ahead of the economy,” said Quincy Krosby, chief global strategist at LPL Financial. “If we see more interest in small caps and financials, that will be a telltale sign that investors are more comfortable about where the economy is heading.”

With the S&P 500 hovering around 4,300 – roughly its peak for the second half of 2022, reached in August – traders are turning to cheap call options. These contracts give the right but not the obligation to buy an underlying asset at a fixed price within a fixed period. S&P 500 futures rose 0.2% to 4,356.50 at 10:16 a.m. in Tokyo on Monday.

They are likely doing this while simultaneously selling the underlying securities, according to Brian Donlin, head of equity derivatives strategy at Stifel Nicolaus & Co. This frees up cash while allowing them to benefit from the rally.

People are “reducing risk in a portfolio while maintaining a targeted upside,” Donlin said via email. “Calls are cheaper and a fraction of the risk.”

This approach, known as the stock replacement trade, contributed to a breakout in call option volume, which at one point last week accounted for 60% of total put and call volume traded. on US exchanges on everything from individual stocks to benchmark indices. That was the most since April last year, according to data compiled by Bloomberg. Options trading allows investors to capture any advantage while maintaining a somewhat defensive stance, as it is cheaper to dump calls than stocks if strength fades.

The decision to reduce risk in portfolios while maintaining targeted exposure to equities is easy to understand, with concern swirling that the S&P 500’s 20% advance from its October low – meeting the definition of a bull market – could leave the gauge too stretched.

At least one trader seems to be preparing for some violent swings ahead. An investor bought about 100,000 call options on the VIX index on Thursday, betting it will top 23 by mid-July. Wall Street’s main fear gauge hasn’t been this high since March and closed below 14 on Friday.

There is an argument that factors specific to individual stocks are exerting more influence lately, outweighing macroeconomic concerns. The main evidence is that an expected correlation gauge between S&P 500 companies three months ahead fell last week to a level last seen in 2018. Typically, when economic worries are the main driver, stocks become more correlated, not less.

That would be good news for investors worried that a handful of tech high-flyers are fueling the bulk of the S&P 500’s gains lately. Cyclical groups like energy and materials broke out this month to outpace gains in technology, which bodes well for bulls looking for a broader rally.

“There is a lot of optimism that we are moving away from the bull market which is dominated by six or seven megacaps,” said Steve Sosnick, chief strategist at Interactive Brokers. “A wider rally is a more powerful rally.”

(Updates to show that US index futures have risen in the sixth paragraph.)

Bloomberg Businessweek’s Most Read

©2023 Bloomberg LP

Leave a Comment