There’s something disheartening about watching potential gains in the stock market fade away—especially when you contemplated hedging but didn’t follow through. Many investors are feeling that sting and have decided it’s time to actually hedge their positions. They are doing this by purchasing protective put options or selling covered calls on the S&P 500. The S&P 500 options market now reflects a notable level of pessimism, indicating this trend. However, the downside is that the high volume of these hedging activities has skyrocketed the costs, making it tough for those unable to hedge. If stock prices fall in the next month, these investors may be pressured to sell.
Owning a put option in a broad-market fund like the State Street SPDR S&P 500 ETF (SPY), which grants buyers the right to sell at a predetermined price within a specified timeframe, is a strategic way for those who foresee a pullback to mitigate risk. Meanwhile, selling a covered call on SPY allows investors to generate some income while shielding themselves a bit, particularly if they aren’t expecting significant market growth.
To gauge investor sentiment regarding the S&P 500, one can look at the relationship between the prices of out-of-the-money puts (options with a strike price lower than the market price) and calls (options with a higher strike price). This relationship is referred to as RiskDex. It represents the ratio between the normalized prices of a 30-day, one standard deviation out-of-the-money put and call option on SPY. A rising RiskDex indicates that put options are getting pricier compared to calls, suggesting greater concern about a downturn rather than optimism about gains. Right now, this signal is decidedly bearish, sitting at 6:30—a level that has worsened following the S&P 500’s drop in August 2024, initially triggered by an unexpected interest rate hike from the Bank of Japan, which unwound the yen carry trade. It’s interesting to note that similar bearish signals haven’t been seen since 2021, prior to a minor selloff.
Historically, from January 2005 to this past Tuesday, the average closing price for RiskDex was around 3.75, indicating that put options have been roughly 3.75 times more expensive than call options. This situation arises because those looking to hedge drive up put prices, while sellers of covered calls lower call prices. Lately, that ratio has surged past 7.00, which means protective puts are nearly double their usual price in relation to call options. This situation implies that traders are more wary about downside risks than buoyed by opportunities for gains over the upcoming month.
While it’s wise for some investors to moderate their enthusiasm for an AI-fueled bull market by hedging their S&P 500 investments near record highs, it also signals that many who have yet to hedge—due to the high cost of protection—are likely to sell if the market dips. Since the options market often reflects future volatility, it serves as a valuable barometer of investor behavior. Right now, this trend is flashing caution. Scott Nations, the founder and chief investment officer of Nations Index, highlights this.
