Source: Zhitong Finance
US stock traders are preparing for an “extreme situation.”
After the S&P 500 achieved one of its strongest first quarters in decades, investors are preparing for a more extreme situation — US stocks will either soar or plummet. With the beginning of the second quarter, US stocks are at an all-time high. Currently, market demand for put options is at its lowest level in many years. If the market adjusts slightly, put options will pay off. Meanwhile, traders are quietly buying tail risk hedging tools — tools that hardly work when the stock market falls slightly, but provide protection when the stock market fluctuates sharply.
Traders don't care about falling and are looking for broad gains
Taken together, Wall Street doesn't seem particularly concerned about the slight decline. But there is growing concern that unpriced risk could hit the bulls hard. Rocky Fishman, founder of derivatives analysis company Asym 500, said, “You can name a lot of tail risks, and the market has changed a lot, so I'm not surprised by the demand for tail hedging. What surprised me even more was the lack of basic hedging requirements.”
As US inflation continues to decline, the Federal Reserve expressed its willingness to cut interest rates this year, and interest rate volatility fell to the lowest level since February 2022, creating a generally favorable environment for the stock market. The S&P 500 index rose 10% in the first quarter, the strongest start to the year since 2019, and hit 22 new record highs in the first three months of 2024.
As gains were so concentrated on a few key tech giant stocks, investors began to seek value in less popular areas of the market. Small-cap stocks seem to be on the cusp of recovery. The Nasdaq 100 index, which mainly focuses on technology stocks, was defeated by the S&P 500 index in the first quarter, and the index remained leading in the same period last year. Second, the latest example of increased market gains is that about 70% or more of the S&P 500 index's constituent stocks are above the 200-day moving average every trading day, which is the broadest range since 2021.
Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, said: “The market is increasingly confident that the US economy will have a real soft landing, or even no landing. At that time, the overall US economic growth will continue to be steady. It makes sense that a wider range of companies, even those more cyclical in industries such as industry, materials, and energy, can perform well.”
According to Citadel Securities' institutional options department, retail investors are building their longest positions in the bullish options market since the 2021 meme stock boom as short-term traders pour in stocks and stock derivatives to seize the rebound opportunities of Reddit (RDDT.US)'s initial public offering (IPO) and Trump Media & Technology Group (DJT.US).
Second, the S&P 500 index, which expires within a year, is bullish on the cost of an option — there is a 25% chance that the option will be a real option (i.e. 25-delta), while the price of an equivalent put option will fall, which means that investors are ready for the continued rise in the market and are not particularly concerned about a slight correction.
Traders are worried about the “black swan” incident to prevent extreme market conditions
However, as positions surging in volatility increase, traders fear a disaster will occur. The average daily buying volume of the Chicago Board Options Exchange (Cboe) Volatility Index (VIX) in the first quarter was higher than in the previous two quarters. According to the data, the two-month deviation of the index (measuring the cost of a 25 delta call option compared to an equivalent put option) is about the highest level in 5 years.
Mandy Xu, global market analyst at Cboe, said: “Investors are less concerned about valuations, earnings, or any other conventional catalysts that could cause stock market adjustments. However, many people are concerned that a potential black swan event could cause a significant increase in volatility.”
One major risk is the timing and extent of the Fed's interest rate cut this year. Federal Reserve Chairman Powell reiterated on Friday that after the latest inflation data met expectations, the Federal Reserve is in no hurry to relax its policy. Talking about higher, longer-term interest rates could dampen market sentiment in the coming quarter.
Another question is the extent to which the artificial intelligence darling that drives stock indexes to rise can remain reasonable. Barclays strategists warned in a recent report that “position and technical constraints” could prompt tech stocks to lead the first wave of potential sell-offs. However, as of now, these concerns have been contained to a certain extent, and hopes for another strong earnings season may further push valuations higher. This is one reason why protective put options have been “eliminated” by investors, and the upward momentum is rampant.
Steve Sosnick, chief strategist at Interactive Brokers, said: “Options traders seem to prefer to buy 'FOMO (FOMO) insurance', and there is still a lot of room between pullback and real tail risk.” He pointed out that there is a general lack of hedging in the market.
edit/lambor