Options trading activity is flashing a warning sign about the market
There is nothing more sickening than seeing unrealized gains in the stock market melt away because you thought about hedging but didn’t. Many investors have decided that now is the time to avoid that feeling and are instead hedging by buying protective put options or selling covered calls on the S & P 500 . In fact, so many are doing so that the S & P 500 option market is signaling their extreme pessimism. The danger is these massive hedging trades have now made hedging very expensive, leaving those who aren’t able to hedge likely to hit “sell” if stocks show weakness over the next 30 days. Owning put options – which grant the buyer the right to sell an asset at a stated price by a certain date – on a fund reflecting the broad market like the State Street SPDR S & P 500 ETF (SPY) is a way to tactically hedge downside for those investors who think a pullback is likely. Selling covered calls – in which the buyer has the right to purchase an asset that the options seller already owns – on SPY is a way to generate a little yield and get a modicum of protection for those investors who think a rally is unlikely. That means that the relationship between the price of out-of-the-money puts (put options with an exercise price that is below the current market level) and the price of out-of-the-money calls (call options with an exercise price that is above the current market level) is a great signal about investors’ expectations for the S & P 500. We call that relationship RiskDex. It’s simply the ratio of the normalized price of the 30-day, 1 standard deviation out-of-the-money put option in SPY to the normalized price of the 30-day, 1 standard deviation out-of-the-money call option in SPY. When RiskDex rises that means put options have gotten more expensive relative to call options, and investors are more worried about potential downside than optimistic about upside. Right now, that signal is decidedly bearish, currently sitting at 6.30. It’s more bearish than it has been since the August 2024 drawdown in the S & P 500 that was caused by the surprise rate hike from the Bank of Japan and subsequent unwinding of the yen carry trade . Before that brief blip, you would have to go back to 2021 to find a more bearish signal. At its current level, RiskDex means investors are much more worried about downside than optimistic for upside. From January 2005 through the close of trading on Tuesday, the average closing level of RiskDex, the ratio between put option prices and call option prices, is 3.75. Put options are historically 3.75-times more expensive than call options because hedgers are bidding up the price of those puts and covered call sellers are pushing down the price of call options. But recently that ratio has ventured above 7.00. It closed at 7.12 on Tuesday, meaning protective puts are nearly twice as expensive – in relation to call options – as they normally are. The warning is that traders see much more potential for downside than upside over the next 30 days. It is a good thing that some investors have tempered their expectations for the artificial intelligence-driven rally and are hedged with the S & P 500 near all-time highs. But this also means that many investors who haven’t yet hedged because protective options are so expensive are ready to sell shares in the face of weakness. Since option markets are about future volatility, they often signal what investors and traders are likely to do. Their positioning is a signal that we should be watching. Right now, the signal is a warning. Scott Nations is the founder and chief investment officer of Nations Indexes, an independent developer of volatility and options strategy indexes.
<
