Equity traders looking to hedge the Fed higher with call options

(Bloomberg) — Investors are lining up call options as they prepare for the pivotal 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 US exchanges sometime last week showed the largest bias toward calls in 14 months, according to data compiled by Bloomberg. Using calls allows investors to pick up the upside if the bull market proves resilient, while remaining defensive as they worry about what the Fed might signal this week about its policy path.

The central bank is expected to stop tightening on Wednesday for the first time in 15 months. The danger, however, is that a resilient economy keeps inflation stubbornly high, prompting officials to pick it up again as soon as next month or keep borrowing costs high for a while longer. That could affect interest rate-sensitive big tech stocks that have been key to the market’s gains.

All of this makes this Fed decision and subsequent comments by Chairman Jerome Powell as crucial as investors’ attitude for the rest of the year. Tuesday’s CPI reading also takes on additional significance, as indicators of subduing inflation could boost equities, including areas such as banks and small businesses that are closely linked to the health of the economy.

“There will always be a wall of anxiety, but historically the stock market sees better times ahead before the economy does,” said Quincy Crosby, chief global strategist at LBL Financial. “If we see more interest in small businesses and financials, that would be a clear indication that investors are feeling more comfortable about the direction the economy is headed.”

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With the S&P 500 hovering around 4,300 — around its peak in 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 were up 0.2% at 4,356.50 as of 10:16 a.m. in Tokyo Monday.

They’re likely doing this while selling the underlying security at the same time, according to Brian Donlin, head of equity derivatives strategy at Stifel Nicolaus & Co., which saves money while allowing them to profit from the rally.

People are “reducing risk in the portfolio while maintaining an upside target,” Donlin said via email. “Calls are cheaper, and part of the risk.”

This approach, known as stock replacement trading, has contributed to a hack in the volume of call options, which at one point last week accounted for 60% of all put and call volume traded on US exchanges on everything from individual stocks to gauge indexes. That was the most since April of last year, according to data compiled by Bloomberg. Options trading allows investors to get on any upside while remaining somewhat defensive, since it is cheaper to dump calls than stocks if the strength wears off.

The move to reduce risk in portfolios while maintaining target exposure to equities is easy to understand with concern that the S&P 500’s 20% advance from its October low — meeting the definition of a bull market — could leave the metric stretched too far.

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At least one trader seems to be preparing for wild swings ahead. On Thursday, an investor bought about 100,000 call options on the VIX index, and will top 23 by mid-July. The main measure of fear on Wall Street has not been this high since March, and closed below 14 on Friday.

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

This could be good news for investors worried that a handful of big tech leaders are fueling the bulk of the S&P 500’s recent gains. Cyclical groups such as energy and materials broke out this month to outpace gains in tech, which bodes well for bulls looking to expand higher.

“There’s a lot of optimism that we’re getting away from the bull market that’s been dominated by six or seven huge companies,” said Steve Sosnick, chief strategist at Interactive Brokers. “A broader rise is a stronger rise.”

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

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