A growing number of investors are using derivatives to hedge their equity holdings following a remarkable stock-market rebound over the past several months amid a global pandemic.
The S&P 500 is within touching distance of the record close it reached in February, having almost recovered from a 34% plunge earlier this year after the coronavirus forced large sections of the global economy into lockdown.
That sustained rally – helped in no small part by extraordinary central bank and fiscal stimuli – has confounded sceptics convinced that equities would inevitably falter in the face of dire economic data.
But market data suggest a rising number of investors are growing uneasy with the apparent disconnect between markets and the real economy. A recent JP Morgan report reveals investors now heavily favour put options to protect against an equity market slide over call options providing exposure to a further upswing.
That backs up anecdotal evidence from bankers, who say clients such as hedge funds and large institutional investors have looked to lock in gains in recent weeks.
"We have clearly seen an increased level of hedging across a wide spectrum of clients," said Julien Bieren, global co-head of equity derivatives structuring at Credit Suisse.
"We've seen institutional clients looking to be much more systematic in their hedging, or people in the [over-the-counter derivatives] space looking to take advantage of dislocated parameters."
The speed of the stock-market recovery has surprised many observers given the steep drop in economic output in many countries. The US and German economies contracted at their sharpest rates on record in the second quarter of the year, while the UK economy shrank by more than 20% – the worst of major developed nations.
Yet stock markets have barely flinched. After trading sideways for much of June and July, the S&P 500 has ticked up again in August, powered higher in part by gains in technology stocks. The pan-European Stoxx Europe 600 index is also up more than 30% from its March low, though still remains some way off its record close in February.
Despite this apparent exuberance, there are signs that investors have been covering themselves against another market dip. The total open interest of S&P 500 put options is now 1.8 times higher than call options, according to the JP Morgan report. That compares with 1.3 times in mid-June as demand for protection against a stock market slump is growing.
Options markets also point to higher demand for Euro Stoxx 50 crash protection, the report said. "Our analysis continues to point to heavier demand for put options," the JP Morgan strategists said.
Kokou Agbo-Bloua, global head of flow strategy and solutions at Societe Generale, said hedge fund clients in particular had been reducing risk.
"A lot are worried about a second wave of Covid-19 in terms of corporate bankruptcies. Some feel that a lack of liquidity in the summer months could be a catalyst for an equity market correction. They don't want to have big positions on when liquidity is poor," he said.
One problem facing investors: hedging equity holdings is far more expensive than prior to this year's crisis. That can be seen in equity volatility levels, a proxy for the cost of options.
The CBOE's Volatility Index (which tracks S&P 500 options) is nearly twice the level of earlier in the year, at about 22 points.
BNP Paribas recently suggested the VIX should be nearly a third lower than its current level given how it has historically behaved in relation to other market parameters such as share prices.
The fact that it remains elevated despite current equity market performance may well reflect the considerable uncertainty over the trajectory of markets, the global economy and the coronavirus pandemic.
The higher cost of options has prompted many investors to consider ways to lower their hedging costs, bankers say.
"That could involve buying puts while reducing the cost with some conditionality, given that volatility is very expensive," said CS's Bieren.
Some may feel paying up for protection is worth it anyway given how far equities have risen in such a short time.
"It won't be as cheap as before the crisis, but the risk-reward is still pretty compelling," said Agbo-Bloua.