The Smart Money Is Still Hedging Its Bets on Stocks – Barron's

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Even the most casual reader of financial media could get the idea that no one with a functioning intellect is hedging a historically high stock market.

All investors, great and small, are, as the common narrative goes, continuing to buy the dip because that has worked beautifully since about March of 2009. While that approach does indeed retain some merit, don’t believe the nonsense that sophisticated investors are letting risk, unrealized capital gains, and historically low index and equity volatility flap in the market’s wind like a tarp that hasn’t been tied down.

INDEX PUT SKEW remains elevated, which indicates that investors are indeed buying puts to hedge markets. Puts, as most know, increase in value when associated security prices decline. If investors are concerned that the Standard & Poor’s 500, or some other benchmark index, might edge lower from historical highs, they buy puts. And such trades are happening every day—even if they don’t fit the public narrative that basically expresses itself as buy, buy, buy.

Last Tuesday, for example, in the first 30 minutes of trading, an investor bought 30,000 SPDR S&P 500 ETF Trust (ticker: SPY) June $230 puts at $1.34 in one transaction, when the exchange-traded fund was around $274. The most likely explanation is that the purchaser was hedging the gains in a stock portfolio that tracks the S&P 500.

Moreover, calls on the CBOE Volatility Index, or VIX—often described as the S&P 500 put on steroids—remain perennially active. Investors buy VIX calls when they think S&P 500 volatility will increase. If the VIX rises, the calls increase in value.

In a trade that can be considered emblematic of positioning that is often too complicated for many pundits and inexperienced reporters, a major investor adjusted a massive hedge. The investor bought nearly 107,000 VIX February $17 calls and sold close to 192,000 VIX February $192 calls. The spread basically expressed a view that VIX would remain below $17 through February expiration. The $22 call was the hedge against that proving wrong. The investor opened a new position, selling about 177,000 March $17 calls and buying about 210,000 March $22 calls.

The VIX activity is a reminder that only knuckleheads don’t manage risk. The interest in hedging, or positioning for volatility to pop, probably explains the recent rally in shares of Cboe Global Markets (CBOE), which exclusively lists futures and options on VIX, and options on the S&P 500. Cboe’s stock just reached an all-time high.

In short, people without much money rarely hedge. Why? Their greater risk is not making money, rather than protecting what they have. The risk is different at higher income levels.

At Oppenheimer, for example, Michael Schwartz, the firm’s chief options strategist, says clients increasingly want to hedge stocks. “Everyone wants to buy puts,” Schwartz said. “No one believes the market won’t come down at some point.”

AND NOT WITHOUT REASON. Bank of America Merrill Lynch strategists, for example, recently told clients 2017 was the fourteenth year without the S&P 500 closing below its 200-day moving average, which is rare.

Schwartz has advised clients to consider buying puts on the technology sector. His recommended hedge: purchasing Powershares QQQ Trust Series 1 April $160 puts (QQQ) for $3.83, when the underlying exchange-traded fund was at $162.58. If the ETF declines by 6.12%, the put buyer realizes a 100% return. If the market keeps advancing, reset the trade and adjust the strike price to reflect QQQ’s higher price.

Bottom line: A hedge preserves your edge.


STEVEN SEARS is the author of The Indomitable Investor: Why a Few Succeed in the Stock Market When Everyone Else Fails.

Comments: steve.sears@barrons.com

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