Equity traders seeing Fed hedge for rally with call options

(Bloomberg) — Investors are stocking up on call options as they prepare for a key Federal Reserve decision that is set to dictate the tone for stocks heading into the second half of 2023.

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Options trading on U.S. exchanges at one point last week showed the biggest bias toward calls in 14 months, data compiled by Bloomberg show. Using calls allows investors to capture the upside if the bull market proves resilient, while still remaining defensive because they are wary of what the Fed might signal this week on policy.

The central bank is expected to stop tightening on Wednesday for the first time in 15 months. The risk, however, is that a resilient economy keeps inflation stubbornly high, pushing officials to hike again as soon as next month or keep borrowing costs high for longer. That could weigh on the price-sensitive Big Tech shares that have been the key to the market̵[ads1]7;s gains.

It all makes this Fed decision and Chairman Jerome Powell’s subsequent comments critical as investors’ position for the rest of the year. Tuesday’s consumer price index reading also takes on added significance, as signs of easing inflation could boost stocks, including areas like banks and small caps that are closely tied to the health of the economy.

“There will always be a wall of concern, but the stock market historically sees better times ahead for the economy,” said Quincy Krosby, global chief strategist at LPL Financial. “If we see more interest in small caps and financials, that would be a clear sign that investors are more comfortable with where the economy is going.”

With the S&P 500 hovering around 4,300 — roughly the top for the second half of 2022, reached in August — traders are turning to cheap call options. These contracts give the right, but not the obligation, to buy an underlying asset at a specified price within a specified time frame. S&P 500 futures rose 0.2% to 4,356.50 at 10:16 a.m. in Tokyo on Monday.

They likely do so at the same time they sell the underlying securities, according to Brian Donlin, head of equity derivatives strategy at Stifel Nicolaus & Co. It frees up money while allowing them to benefit from the rally.

People “reduce risk in a portfolio while maintaining targeted upside,” Donlin said by email. “Calls are cheaper and a fraction of the risk.”

That approach, known as a stock-replacement trade, has contributed to a burst in call volume, which at one point last week accounted for 60% of the total volume of calls and calls traded on U.S. exchanges on everything from individual stocks to benchmarks. That was the most since April last year, data compiled by Bloomberg show. The options trade allows investors to capture any upside while maintaining a somewhat defensive stance, as it is cheaper to dump calls than stocks if strength wanes.

The move to de-risk portfolios while maintaining targeted stock exposure is easy to understand, with concerns that the S&P 500’s 20% advance from its October low — which meets the definition of a bull market — could make the gauge overextended.

At least one trader appears to be bracing for wild swings ahead. On Thursday, an investor bought about 100,000 call options on the VIX index, betting it will exceed 23 by mid-July. Wall Street’s main fear gauge hasn’t been this high since March, closing below 14 on Friday.

There is an argument that factors specific to individual stocks are more influential recently, outweighing macroeconomic concerns. The main evidence is that a measure of the expected correlation between S&P 500 companies three months from now fell last week to a level last seen in 2018. Typically, when economic concerns are the main driver, stocks become more correlated, not less.

That would be welcome news for investors worried that a handful of tech high-flyers are driving the bulk of the S&P 500’s recent gains. Cyclical groups such as energy and materials have broken out this month to outpace technology gains, which bodes well for bulls looking for the rally to extend.

“There’s a lot of optimism that we’re getting out of the bull market dominated by six or seven megacaps,” said Steve Sosnick, chief strategist at Interactive Brokers. “A wider rally is a stronger rally.”

(Updates to show US index futures rose in sixth paragraph.)

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