Traders Buy Hedges ‘Like World Is About to End’

[tacobell fan]

U.S. stocks have barely budged this week, but the calm in equities contrasts with a frenzied bout of hedging in options markets.

Faced with a loaded event calendar that will bring central-bank decisions, trade deadlines, a U.K. election and possibly an impeachment vote, traders are piling into protection “like the world is about to end,” quipped IPS Strategic Capital head trader Patrick Hennessy on Twitter. Meanwhile, the S&P 500 drifted for a second straight day in thin volume.

The divergent behavior is reminiscent of trends ahead of the Brexit referendum and U.S. elections in 2016, Hennessy said, when there was a chasm between the S&P 500’s low realized volatility and high demand for puts relative to calls. Like then, traders are now are bidding up tail protection and skew -- the gap between the implied volatility of S&P 500 puts versus calls.

The jump in implied and realized correlations shows that investors are again treating this like a macro-driven market -- one in which stocks will tend to move together. And with the aforementioned plethora of potential catalysts on deck, it’s little wonder.

And this hedging activity could also be the fuel for a fresh record in equities in short order. The flip side is that if this macro minefield is successfully navigated, an unwind could power risk assets ever higher.

“Downside protection in S&P is extremely rich, while upside sees little to no interest,” said Charlie McElligott, equity derivatives strategist at Nomura Securities. “The market is now once again beginning to price in ‘tail’ scenarios.”

This build-up of hedges makes sense, according to the strategist, given his assessment of relatively elevated equities positioning. But even so, this opens up the possibility that stocks can jump higher in the event of a hedge “puke,” as McElligott puts it, or on clarity that tariffs scheduled to go into effect this weekend will be delayed, with the potential for previous levies to be rolled back.