As U.S. stocks trade at all-time highs, the price tag on bearish options has dropped to a trough relative to bullish contracts. The spread between the price of one-month, 25-delta puts and calls for the S&P 500 is roughly two standard deviations below its five-year mean, data compiled by Bloomberg show. It’s an indication of the greed -- or lack of fear -- in the market suppressing the CBOE’s volatility gauge.
The persistent decline in put prices -- paying less for downside protection -- drove the downtrend in the measure known as skew during most of last year’s second half. Since Jan. 3, investors chasing upside have led to an increase in the cost of calls, contributing to the historically significant level of bullish positions, the data show.
More than 5.4 million S&P 500 calls have already changed hands in 2018, the most on record to kick off the new year.
Buy PUTS Now
Pitching hedges when the market is in the middle of a blow off top is a tough sell. But, according to Chris Metli, executive director of Morgan Stanley's Inst. Equity Division, that's exactly what traders should be doing, for three reasons: 1) positioning, 2) pricing, and 3) potential catalysts, which "all suggest now is an attractive time to buy Feb puts as a hedge – and it is a rare event when all align."
Here is how one of the top Morgan Stanley cross-asset quants justifies his reasoning:
First, this is not a call for the final top – positive sentiment and positioning can have momentum of their own and absent some kind of shock likely take the market higher. But the rally is getting more fragile – as MS Equity Strategist Mike Wilson notes in Weekly Warm-up: Euphoria! (Jan 16, 2018) "The bottom line is that we have entered the late cycle euphoria stage we predicted a year ago.” and “it is more likely the S&P 500 will reach our bull case of 3,000 before it's over. We just want to make sure investors appreciate this is higher, not lower risk than the rally we experienced last year.”
1. The rally is getting riskier because of positioning – investors have aggressively chased beta with both futures and options. Over the last two weeks, investors have bought the 2nd largest amount of S&P 500 futures (as measured by MS Trade Pressure) since at least 2010, while at the same time net holdings of S&P 500 calls are the highest and the net holdings of S&P 500 puts are the lowest since at least 2010.
2. That demand for upside and lack of interest in protection has driven short-dated skew down to near post-crisis lows, making puts cheaper. This flattening of skew is a sharp turnaround from the historical highs seen just last October and bucks the structural steepening of the last several years .
3. Finally, there is actually a potential catalyst with a potential government shutdown this Friday, January 19th**,** as well as the State of the Union on the 30th. Shutdowns rarely have any lasting impact, but historically have resulted in short-term equity drawdowns, and it appears that the probability of an adverse outcome this time around is rising.
Late Stage Euphoria
If Morgan Stanley believes this is late stage euphoria, the thing to do is raise cash, not buy hedges. Don't expect a "get out now warning" because there won't be one, and only a few can get out anyway.
Mike "Mish" Shedlock