Stocks Traders Eyeing Fed Pause Hedge Rally With Call Options

(Bloomberg) — Investors are loading up on call options as they brace for a pivotal Federal Reserve decision that’s set to dictate the tone for equities heading into the second half of 2023.

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Options trading on US exchanges at one point last week showed the biggest bias toward calls in 14 months, data compiled by Bloomberg show. Using calls lets investors capture the upside if the bull market proves resilient, while still remaining defensive because they’re wary of what the Fed might signal this week about its policy path.

The central bank is expected to pause its tightening on Wednesday for the first time in 15 months. The risk, however, is that a resilient economy keeps the inflation rate stubbornly high, pushing officials to hike again as soon as next month or keep borrowing costs elevated for longer. That could weigh on the rate-sensitive Big Tech stocks that have been key to the market’s gains.

It all makes this Fed decision and Chair Jerome Powell’s subsequent remarks critical as investors position for the rest of the year. Tuesday’s consumer price index reading takes on added significance, too, as signs of ebbing inflation could buoy shares, including areas like banks and small caps that are closely tied to the health of the economy.

“There’s always going to be a wall of worry, but the stock market historically sees better times ahead before the economy does,” said Quincy Krosby, chief global strategist at LPL Financial. “If we see more interest in small caps and financials, it will be a telling sign that investors are more comfortable about where the economy is headed.”

With the S&P 500 hovering around 4,300 — roughly its peak for 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 set timeframe.

They’re likely doing that while simultaneously selling the underlying securities, according to Brian Donlin, head of equity derivatives strategy at Stifel Nicolaus & Co. That frees up cash while still allowing them to benefit from the rally.

People are “reducing risk in a portfolio while maintaining targeted upside,” Donlin said by email. “Calls are cheaper, and a fraction of the risk.”

This approach, known as a stock-replacement trade, has contributed to a breakout in the volume of call options, which at one point last week made up 60% of the total volume of puts and calls traded on US exchanges on everything from individual stocks to benchmark indexes. That was the most since April last year, data compiled by Bloomberg show. The options trade lets investors capture any upside while maintaining a somewhat defensive posture, since it’s cheaper to dump calls than stocks if the strength fades.

The move to reduce risk in portfolios while maintaining a targeted equity exposure is easy to understand with concern swirling that the S&P 500’s 20% advance from its October low — meeting the definition of a bull market — could leave the gauge overextended.

At least one trader seems to be bracing for violent swings ahead. On Thursday, an investor bought about 100,000 call options on the VIX Index wagering it will exceed 23 by mid-July. Wall Street’s chief fear gauge hasn’t been that high since March, and closed below 14 on Friday.

There is an argument that factors specific to individual stocks are wielding more influence lately, outweighing macroeconomic concerns. The chief evidence is that a gauge of expected correlation between S&P 500 companies three months from now dropped last week to a level last seen in 2018. Typically when economic worries are the main driver, stocks become more correlated, not less.

That would be welcome news for investors fretting that a handful of tech high-flyers are fueling the bulk of the S&P 500’s gains lately. Cyclical groups like energy and materials have broken out this month to outpace gains in technology, which bodes well for bulls looking for the rally to broaden.

“There’s a lot of optimism that we’re getting away from the bull market that’s being dominated by six or seven megacaps,” said Steve Sosnick, chief strategist at Interactive Brokers. “A broader rally is a more powerful rally.”