Options market investors are preparing for a bumpy ride in case of a surprise - be it a good or bad number - from the June U.S. jobs report due out on Friday.
The stock market's wild swings have receded somewhat after Federal Reserve Chairman Ben Bernanke roiled investors with talk on June 19 of a pullback in monetary stimulus, but the nerves of investors and traders remain frayed after those events. Given that the jobs report is the most important monthly U.S. economic release, and could alter expectations for the Fed's actions, this could be a big test of the markets' confidence.
The anxiety is exacerbated by the July 4 U.S. Independence Day holiday. While U.S. financial markets are open for a full day on Friday, many traders and investors tend to take the day off and enjoy a long weekend.
"There is fear going into this holiday period and people are anticipating a large gap higher or lower in U.S. equities after the jobs report," said Steve Place, a founder of options analytics firm investingwithoptions.com in Austin, Texas.
The U.S. Labor Department is expected to report an increase of 165,000 in nonfarm payrolls for June, with the household unemployment rate expected to fall to 7.5 percent from 7.6 percent in May. On Wednesday, the ADP National Employment Report showed a gain of 188,000 for private employers in June, a possible signal of a solid report.
A weaker-than-expected figure could increase pressure on the Fed to maintain its current program of bond buying, which would be seen as positive for the stock and bond markets. But that may be outweighed by concerns about what poor jobs growth would suggest about the economy.
Options activity in the bond market is skewed slightly in favor of higher yields, which suggests investors expect a stronger report. If payroll growth exceeds forecasts sharply - say, a gain of 250,000 jobs - bond prices could plunge, and equities could drop on fears that the Fed would begin to pull back from its bond buying sooner rather than later.
Enis Taner, global macro editor at options research firm RiskReversal.com, said in a report on Wednesday that if the jobs report is strong, "stocks are more likely to sell off as rates move higher (a case of good=bad) because of the market's focus" on the Fed potentially tapering its bond buying program.
A weak figure would disappoint investors, but might be enough to stay the Fed's hand.
"I don't expect markets will sell off if the payroll report is weak because monetary policy is so laser-focused on employment, and a weak report won't add to tapering fears," said Kristina Hooper, head of portfolio strategies at Allianz Global Investors in New York, which manages $400 billion in assets.
"This is the one metric where good is bad and bad is good. In general, though, it is hard to say whether we're 100 percent in that environment still."
Either way, the prospects of greater volatility in the wake of Friday's release has many investors in the SPDR Standard & Poor's 500 Trust (SPY.P) - the most popularly traded exchange traded fund commonly known as the Spiders - taking on positions to protect portfolios and hedge against volatility, Place said.
Various option gauges suggest a cautious tone. Over the past 10 trading days starting June 19, new options positions on the S&P 500 favored puts over calls by more than a 2-to-1 ratio, according to Schaeffer's Investment Research, which reviewed data on three options exchanges.
That ratio is higher than 98 percent of the readings over the past year, suggesting substantial hedging with put options in recent days, said Joe Bell, senior equity analyst at Schaeffer's Investment Research.
Wall Street's fear gauge, the CBOE Volatility Index .VIX, has come down after breaching the 20 level in the wake of Bernanke's comments two weeks ago, but it is still sitting above the year's average. On Wednesday, the index closed at 16.20; it has been below 15 through most of 2013.
"As the market has rallied this week, we did not see much of a decline in the CBOE Volatility Index, presumably because traders are thinking more about the market moving potential of the jobs report," said Jared Woodard, principal of Condor Options, an options research firm in Forest, Virginia.
Joe Tigay, investment advisor at The Stutland Volatility Group, which specializes in option strategies for institutions and retail investors based in Chicago, said demand for out-of-the-money VIX call options has remained steady over the past two days, which he called "sort of a rainy day insurance policy for a potential pullback in stocks and a spike up in volatility."
VIX calls are often used by institutional traders as a hedge against rising volatility.
Concern about volatility in emerging markets has been even higher. Those markets have been battered in the last few weeks, as the expected pullback in Fed stimulus caused a large-scale exiting of long positions in emerging markets. Mass protests in Brazil, Turkey and Egypt haven't helped, and neither has China's crackdown on lending by its so-called shadow banking sector, which is loosely regulated and arranges financing outside the traditional banking system.
Traders on Tuesday traded about 570,000 options on the iShares MSCI Emerging Markets Index Fund (EEM.P), with a put-to-call ratio of 4.45:1, according to options analytics firm Trade Alert. That ratio far exceeds the 22-day moving average of 1.91.
The CBOE Emerging Markets Volatility Index .VXEEM surged nearly 18 percent to 30.18 on Tuesday as traders braced for more turmoil across global markets. It rose further on Wednesday to 30.77, up 1.95 percent.
Bank stocks were also targeted for bearish bets. In the Financial Select Sector SPDR fund (XLF.P), nearly seven puts were bought for every call as a new position on three U.S. options exchanges during the past 10 trading sessions starting June 19, Schaeffer's said. That ratio is higher than 90 percent of the readings over the past 12 months, Bell said.
(Additional reporting by Angela Moon and Julie Haviv in New York; Reporting by Doris Frankel; Editing by Martin Howell and Richard Chang)