Hope for the best. Prepare for the worst.
Such is the message from the options market as the
S&P 500 index
continues to dance on a razor’s edge near record-high territory.
Inflation appears to be cooling, which suggests the Federal Reserve may shy away from more aggressive interest rate increases, benefiting stocks. Yet options trading patterns suggest that sophisticated investors aren’t so sanguine.
This skepticism has led to a surge in investors buying call options on a host of different stocks to participate in a controversial advance that they fret may sputter, if not collapse, because just a few highflying stocks are driving the market’s gains.
Call options, of course, increase in value if the underlying stock price rises, but there’s another important feature that’s making calls quite popular right now: They let investors control stocks for less money and with less risk than buying equities.
That prosaic advantage is often used by institutional investors when they are assembling an investment thesis. While they are doing their research, they buy calls on stocks as placeholders just in case the stock runs away from them before they have reached a conclusion.
That so many investors are so aggressively buying calls suggests a degree of caution that isn’t widely appreciated. If investors were super-confident in the stock market’s rally, they would be more likely to gorge on stocks without using calls as stock proxies. You can think of it as the equivalent of investors holding their noses and buying stocks.
Indeed, the bullish call buying comes as other investors are preparing for the worst. They are buying options that would surge in value if the stock market plummets. In recent sessions, there has been heavy trading in call options on the
Cboe Volatility Index,
or VIX. Unlike calls on stocks, which are a bullish wager, investors buy VIX calls when they think the stock market will sink. If stocks tumble, the VIX increases in value, so calls on the VIX are a way to monetize that fear.
VIX trading patterns paint a cautious picture that is at odds with the fear gauge’s superficial message that investors aren’t concerned about stock risk.
With the VIX around 15—a level that suggests little to no fear about the future—investors have bought 155,000 VIX July $23 calls, 70,000 July $27 calls, and about 140,000 August $20 calls. The trading patterns indicate that institutional investors are hedging their portfolios just in case the stock market sinks and the VIX surges.
As we noted in May, options volatility might be the most attractively priced asset in the global markets. The VIX currently implies the S&P 500 will move less than 1% each day over the next 30 days. Such muted expectations seem incredible given the retinue of risks that exist, ranging from Russia’s invasion of Ukraine potentially turning into World War III to concerns that, despite this week’s good news, the Fed could lose control of inflation and the U.S. economy will go into a recession.
The disconnect between the many risks aligned against the stock market and the rally prompted some wags to observe that the stock market is bullishly climbing a wall of worry. As long as investors keep citing reasons why stocks should decline, stocks tend to advance, because worrying out loud tends to make stocks more attractive to less-fearful investors. History has proven that true many times.
Yet the options market, which is often the place where investors express their views of the future, paints a more cautious picture of investor sentiment.
Steven M. Sears is the president and chief operating officer of Options Solutions, a specialized asset-management firm. Neither he nor the firm has a position in the options or underlying securities mentioned in this column.
Email: [email protected]
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