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As Stocks Soar, Demand For Downside Risk Hedges Reaches Highest Since 2018

As Stocks Soar, Demand For Downside Risk Hedges Reaches Highest Since 2018

While Small Caps have taken a kickin’ recently, the broad stock market continues to ascend Icarus-like to ever higher highs on a bed of global liquidity and hope-filled dreams of a return to an even more utopian (and profitable) normal.

There’s just one thing (well two actually, but more on that later)…

As stocks have hit record-er and record-er highs recently, options traders have been buying puts (downside protection) with both hands and feet…

Source: Bloomberg

As a result, implied volatility in S&P 500 puts that look three months out reached the highest level since 2018 relative to similar call contracts.

Source: Bloomberg

Simply put, despite the appearance of price, investor anxiety is on the rise.

As Susquehanna International Group’s Chris Murphy pointed out in a recent note, the worry is that, should the sentiment sour, correlation between shares that recently hit fresh lows will skyrocket, making stocks drop together at the same time.

“Correlation is currently so low, but if that changes, then everything starts moving together and volatility could move up quickly and the S&P could move to the downside,” Murphy said.

“They’re pricing in that shift of correlation increasing.”

And implied correlation is starting to pick up off those near-record lows…

Source: Bloomberg

Of course, one could argue that with downside risk so well hedged, the chances of a big plunge are reduced (or the magnitude of the drop), but we suspect that doesn’t apply given the retail exposure in this rally, who have never experienced anything more than a 5% drop in their long and successful 12 month trading careers.

And the other group that “ain’t buying it” is bond investors as yields have dramatically decoupled from equity markets’ exuberance in recent months…

Source: Bloomberg

It didn’t end well for stocks last time…

Source: Bloomberg

And with Powell admitting that The Fed is talking about the taper today, are options traders and bond traders sensing a catch down to reality for stocks?

Tyler Durden
Thu, 07/15/2021 – 14:40

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