Cheap Hedging Attractive As Markets Overheat

By Jan-Patrick Barnert and Michael Msika, Bloomberg markets live reporters and strategists

Wall Street’s recent straight-up rally is likely making some investors wary of chasing the gains into year-end. The good news for them is that a sharp drop in volatility is offering the chance to lock in cheap option hedges.

Recent equity moves are unusual in that stock markets from many different countries have turned overbought at the same time, raising the prospect of sudden reversal. Our momentum tracker suggests investors have been using a lot of their buying power in recent days.

To Axel Botte, head of market strategy at Ostrum Asset Management, it looks like “the market wants to believe in a rapid easing of rates from the Fed.” That’s reflected in the outsized reactions to recent economic data releases, Botte adds.

With the bullish year-end narrative in full swing, more gains could unfold in December. Yet as global stocks head for a fourth week of gains, there is a sense of nervousness. While Europe’s Stoxx 600 index isn’t technically overbought yet, it’s testing the upper end of a short-term downtrend channel, as well as its 200-day moving average.

For one, there are signs that systematic investors, who accounted for a lot of recent buying, are cooling on the rally. Goldman Sachs’s models point to CTAs snapping up a net $40 billion worth of S&P stocks in the past week. Now those models suggest “this strong CTA tailwind that has been present in the market is firmly in the 7th or 8th innings and as such, we no longer model them of buyers in S&P 500,” Goldman tells clients, though the bank still sees CTAs as buying global equities.

Big Tech, a major driver of this year’s surge, could also be approaching exhaustion — the positioning of asset managers and leveraged funds on the Nasdaq is now at the highest level since 2017. Investors gave a cool reaction to Nvidia’s latest quarterly report, which blew past average analysts’ estimates but failed to satisfy the loftier expectations of shareholders who have bet heavily on an artificial intelligence boom.

For those looking to proceed cautiously from here, one strategy could be to pick out single stocks. That could prove effective, given this month’s collapse in implied correlations between individual stocks. “Current correlation and dispersion metrics suggest that despite the overbearing influence of top-down forces on global stock return variability, stock selection, as an investment style, is in, or approaching, a ‘sweet spot’,” according to Citigroup’s Chris Montagu.

Options are the other way forward. Volatility has been smashed across the board, from single stock readings to skew as well as VVIX, the gauge measuring volatility of the VIX index. The reading on every single one of these indexes is back to or very close to pre-summer lows. That makes it cheap to buy options to hedge one’s positions, whether for short-term plays or heading into 2024.

With the VIX vol gauge reverting to its mean and approaching some kind of a floor around the 13 level, the question is whether investors might use the reading to switch some of their long positions into upside call options or hedge some of their bumper returns from recent weeks and months.

The volatility curve “carries barely a blip of concern,” according to strategists at Tier1Alpha. “The predictable collapse in intraday volatility tied to our return to positive gamma is yet another indication that the apocalypse has been postponed.”

“Party hats will be distributed,” they add.