Investors seek more protection from a market downturn

A choppy week for the S&P 500 index led long-time complacent traders to look at hedges they had ignored for months.

Insurance demand in the broad market fell to multi-year lows in the first quarter as U.S. stocks hit a series of new highs despite rising geopolitical tensions and interest rate uncertainty. This week, that changed as the desire to protect against a recession increased with a series of measures.

"People are starting to recognize that we've overlooked these first three months of the year, all in the face of rising interest rates, all in the face of eliminating the likelihood of cuts," said Joe Mazzola, director of commerce and education at Carlos Schwab & Co. "Something has to give at some point."

The Cboe Volatility Index, known as VIX, closed on Thursday at its highest level since November, before falling on Friday as US stocks rose. The index, a measure of the S&P 500's 30-day implied volatility based on out-of-the-money options prices, still held above its 200-day moving average.

Since late March, investors have been slowly adding hedges, driving the cost of three-month bearish put options to the highest premium over bullish contracts since mid-January. Those positions were added to the insurances that have received the most attention this year: tail risk coverages that protect against a major drop, rather than a minor correction.

Some investors are using spreads, which offer less protection against a downturn but cost much less than direct contracts. Susquehanna International Group highlighted recent put spreads set for reductions in the S&P 500, technology sector Nasdaq 100 and Russell 2000, often seen as a benchmark of the health of small cap companies.

Stephen Solaka of Belmont Capital Group, which manages hedging strategies for wealth management firms and institutions, said more and more clients have been requesting portfolio hedges linked to both equity benchmarks and individual technology companies.

"That's a function of prices and the progress we've had," he said. According to Solaka, the lawsuit makes sense: After the S&P 500's dizzying rally, investors may want to protect their gains. "It's natural."

These days, traders' angst is focused on a series of unknowns: geopolitical tensions, the upcoming US presidential election, first-quarter earnings reports and, of course, central bank policy. That last wild card came to the fore last week after Federal Reserve Chairman Jerome Powell said bankers don't need to rush to ease borrowing. Neel Kashkari of the Federal Reserve further soured the mood when raised the possibility of no rate cuts in 2024.

An increase in selling volume linked to the iShares iBoxx High Yield Corporate Bond ETF (ticker HYG) indicated that investors are preparing for the Federal Reserve to disappoint again. Hedges tied to the fund would likely pay off if tight Federal Reserve policy pushed the rate-sensitive fund lower.

"If you think about what's been driving some of the real macroeconomic volatility, it's been interest rates," said Alex Kosoglyadov, managing director of equity derivatives at Nomura Securities International, noting that fewer cuts than markets expect could catalyze stock movements. "The Federal Reserve is a risk that could bring down the market."

Options positioning reflects action in the stock market, which has favored established mega-caps over riskier stocks. Growth and quality ETFs reaped massive inflows compared to the meager inflow of value funds throughout March.

Demand for protection comes down to traders' expectations, according to Rohan Reddy, research director at Global X Management. With a growing consensus in favor of a soft landing, unwanted surprises can cause a bit of angst in even the bravest bull markets.

“Of course, there is a real possibility that things get tough, in which case there may be more desire to protect,” Reddy said.

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