Analysis: As the Fed tightens, US equity investors defend themselves in the options market

NEW YORK, April 14 (Reuters) – US equity investors are increasingly turning to the options market to protect themselves from further downside on Wall Street amid fears the Federal Reserve will become less sensitive to stock market volatility, when it raises interest rates to fight inflation.

Demand for puts, typically bought to protect against downsides, is in line with a trend that has seen investors ramp up their hedging in recent months as the Fed’s hawkish bias roiled markets after years of double-digit gains.

The one-month moving average of open puts for each open call on the SPDR S&P 500 ETF Trust (SPY.P)is at 2.25, its most defensive reading in at least four years, Trade Alert data showed.

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Stocks have pared losses over the past month, but the recovery stumbled in April and exited the S&P 500 (.SPX) down 7% year-to-date. The Cboe Volatility Index (.VIX)Wall Street’s “fear gauge,” recently stood at 21 and has spent most of 2022 well above its historical median of 17.6.

“It all goes back to the Fed put … where the Fed doesn’t have the stock market’s back right now,” said Chris Murphy, co-head of derivatives strategy at Susquehanna.

The term “Fed put,” as investors describe the market’s belief that the central bank will stop tightening or even loosen monetary policy if stocks fall too much. A recent example investors often cite is 2019, when the Fed halted its rate-hike cycle after the stock market collapsed. Continue reading

However, some investors believe policymakers are likely to be less responsive to the market weakness this time as the central bank signals it is ready to fight the worst inflation in four decades with massive rate hikes and a swift run-down of its balance sheet. Continue reading

“High and persistent inflation is transforming the Fed from a volume suppressor and yield suppressor to a volume suppressor and yield suppressor,” analysts at BofA Global Research said in a note on Tuesday.

Fund managers in the bank’s latest survey said they believe the S&P 500 would have to fall to 3637 before the Fed steps in to support markets — about 13% off this year’s lows. Another sign of nervousness came as fund managers’ liquidity allocations neared their highest level since April 2020.

Equity investors could also be nervous that the turmoil in bond markets could potentially spill over into equity markets, said Anand Oprakash, head of quantitative strategy for derivatives at Elevation Securities.

The ICE BofA MOVE Index (.MOVE)a measure of expected volatility for US Treasuries, remains close to the two-year high set in early March.

A growing number of investors have also taken advantage of the strength of stocks to purchase option protection. This is a departure from the ingrained trend of “buying the dip,” in which investors put money by buying more shares when the market is down.

“Levels of volatility are offered because when we see stocks rallying, when we see volatility coming in, investors are quick to jump into it,” Susquehanna’s Murphy said.

The Russell 2000 small-cap index (.FURROW) and the S&P 500 retail exchange-traded fund (XRT.P) have also positioned defensive options in recent weeks, analysts said.

Steven Sears, president of Options Solutions, an investment adviser specializing in options strategies for high net worth individuals, said a bleak outlook for markets combined with sizable unrealized gains booked by investors over the past year has prompted more clients to seek protection.

“They’re trying to lock in those profits without selling,” Sears said.

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Reporting by Saqib Iqbal Ahmed; Edited by Ira Iosebashvili and David Gregorio

Our standards: The Thomson Reuters Trust Principles.

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