Traders Hedging Record Rally Dabble in Exotic Options

Yahoo

2 days ago

(Bloomberg) -- Investors looking to protect against a pullback with stocks at peaks are venturing beyond plain-vanilla options.
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The steady grind higher in the S&P 500 Index has pushed most gauges of implied and realized volatility to the lowest levels in months — in some cases years. The collapse in volatility after the April tariff shock has surprised many investors, given the geopolitical tensions and uncertainty around the impact of levies on corporate earnings.
With a whiff of complacency in the market and a resurgence of meme-stock mania signaling euphoria among investors, strategists across Wall Street are talking more about picking up some protection against a retreat from the highs. Hedging is likely to gain traction both in the context of upcoming earnings and tariff deadlines, and the seasonal trend for the Cboe Volatility Index to rise through the third quarter from July lows.
But simple strategies can be tricky in a rising market, where the few, small dips are seen as buying opportunities. Vanilla put options quickly fall out of the money as the index rises, forcing investors to keep shifting positions higher to maintain their desired level of downside protection.
So strategists are pitching over-the-counter alternatives. At UBS Group AG and JPMorgan Chase & Co., they have recently recommended so-called lookback or re-settable put options, where the strike follows the market higher and — in the case of lookback puts — is set at the highest closing print during the life of the trade. Those are currently trading at a historically narrow premium to vanilla puts, JPMorgan strategists including Bram Kaplan wrote in a note earlier this month.
'Hedging is very much in focus,' said Antoine Porcheret, head of institutional structuring for the UK, Europe, Middle East and Africa at Citigroup Inc. 'We have seen decent buying flows in the lookback put as it is cheap by historical standards since the value of the lookback feature is a function of implied volatility, which is low.'
UBS strategist Kieran Diamond wrote in note last week that historically, a market on the highs is more likely to go higher than reverse, thus increasing the chance of a vanilla put struck today becoming deeper out of the money.
A lookback put implemented from a market high would have shifted the strike of a two-month put at 95% of the spot level 3.4% higher on average over the past 10 years, and the lookback feature costs only 0.4% more than the vanilla put, he said.
The best scenario to buy a lookback put is when the market rallies and then collapses. In such cases, the additional payoff versus the vanilla version can be significant.
'There was a wave of interest in the lookback hedge payoff earlier in the year, when spot was near highs and vols had dropped towards lows,' said Pete Clarke, UBS's global head of volatility strategy. 'Following the latest rally and vol reset, we've seen them actively quoted once again.'
S&P 500 futures were 0.2% higher as of 6:40 a.m. New York time on Monday.
Markets get another test in the coming week with the Federal Reserve rate decision, US employment and gross domestic product data, and the tariff deadline — plus a slew of big tech earnings.
Meanwhile, the re-emergence this month of wild swings in meme stocks will also likely have institutional investors reaching for protection trades, rather than chasing further gains. In 2021, retail-frenzied gains marked a spurt of euphoria for stocks, with moves that quickly faded.
The interest in lookback puts 'is mostly from accounts other than hedge funds, such as long-only asset managers and private banks,' Porcheret said. 'Hedge funds and especially volatility-arbitrage accounts tend to opt for cheapened downside structures as opposed to a lookback which carries additional cost.'
Volatility on technology stocks has been hit especially hard, with Asym 500 founder Rocky Fishman pointing out in a note last week that 10-day realized volatility on the Nasdaq 100 Index had fallen to the lowest level since 2021.
'Nasdaq and generally Tech has been a popular underlying as the volatility there has been especially crushed,' Porcheret said.
(Updates with S&P 500 futures in 11th paragraph. An earlier version corrected spelling of firm name in penultimate paragraph.)
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