Column: Wall St flocks to cheap options for protection

4 minute read

Traders work on the floor of the New York Stock Exchange (NYSE) in New York City, U.S., February 18, 2022. REUTERS/Brendan McDermid

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ORLANDO, Fla., Feb 25 (Reuters) - At the start of the year, the notion that investors would be scrambling to protect themselves from a bear market on Wall Street was unlikely, fanciful even. Now? Not so much.

"Out-of-the-money" options activity suggests that is exactly what investors have done recently amid the swirl of volatility kicked up by fears over higher U.S. and global interest rates, and rising tension between Russia and Ukraine.

Early on Thursday morning Russia invaded Ukraine, plunging Europe into its deepest crisis since the Second World War, according to some observers, and sending world markets into a spin.

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Political, economic, military, and market risks are now substantially higher than even only a few weeks ago, forcing investors to protect their portfolios as best they can. One of the simplest and cheapest ways to do that is via "OTM" options.

"Out-of-the-money" options are especially cheap to buy or sell because the prospect of their strike price being hit spans varying degrees of unlikely.

An option gives the buyer the right to buy or sell a security at a given price on a given date. Buying a "call" option is essentially betting the underlying asset will rise in price, while the opposite holds for a "put" option.

The two most liquid S&P 500 (.SPX) index options have strikes at 4,000 and 3,000 points. Both of these are below Thursday's market close of 4,288.70 points, and far from the index's all-time closing high of 4,796.56 on Jan. 3.

A fall to 4,000 would not pass the official threshold defining a bear market, a 20% closing peak-to-trough decline, but 3,000 certainly would. This particular option, which expires on March 17, bears closer examination.

It is by some distance the second-most liquid of the 2,819 options expiring in the next three weeks, with open interest at 92,583 contracts. That is up from around 60,000 at the start of the year and double the level from mid-December.

What makes the activity around this option especially noteworthy is that it is significantly "out of the money," with its strike price of 30,00 some 30% below the index's current level. This is the furthest "out-of-the-money" option that can reasonably be deemed highly liquid.

There is a put option with a 3,000 strike expiring on March 3 that is even more out of the money, but open interest is under 5,500 contracts. There is a put option with a 2,800 strike and March 3 expiry, but open interest is barely 5,000 contracts.

This shows there is sizeable and growing interest by investors to protect their U.S. equity holdings in the event of a significant decline in the benchmark S&P 500 index of around 30% in the coming weeks.

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"People are looking for protection in the market. Look at how much the volumes and price changes in these 3,000 puts have increased," said Matt Orton at Carillon Tower Advisers.

"There has been a big change in how investors are using options. Last year it was leveraging upside bets via massive out-of-the-money calls. Now, people are using options more to hedge their portfolios, which represents a healthier change," he said.

The last few weeks have brought that need to hedge into sharp focus.

Futures markets have priced in more than 150 basis points of policy tightening this year as the Federal Reserve tries to bring inflation down from its 40-year peak. This will have to be done against the backdrop of war in Europe, soaring energy prices, and major geopolitical instability.

To be sure, some of the froth has come off U.S. money markets, and there is no shortage of calls to buy in to these bouts of weakness and uncertainty, chief among them from Citi and JP Morgan's investment strategy teams.

But demand to hedge downside risk for the S&P 500 via put options is roughly twice as strong as demand for calls.

Europe's largest asset manager, Amundi, which controls 2 trillion euros ($2.25 trillion) in assets, advises clients to continue hedging their investments as best they can because the impact of Russia's invasion of Ukraine is not yet fully understood. read more

"Protection is currently working, and as the market moves, we will need to readjust to even possibly lower downsides," its investment management team wrote on Thursday.

"This is not time to ... remove hedges. Overall, we continue to stay cautious."

(The opinions expressed here are those of the author, a columnist for Reuters.)

($1 = 0.8883 euro)

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By Jamie McGeever in Orlando, Fla. Editing by Matthew Lewis

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Opinions expressed are those of the author. They do not reflect the views of Reuters News, which, under the Trust Principles, is committed to integrity, independence, and freedom from bias.