If You Already Sold It All, You Don’t Need To Hedge…

Right up until Wednesday at lunchtime, when Jerome Powell saved the world from himself, there was a lot of fear out there.

Equities were in a tailspin prompting Donald Trump to cast Powell as the Skeletor to his He-Man, credit spreads were blowing out and leveraged loans, one of 2018’s only winners, were starting to look shaky as well.

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Perhaps most disconcerting of all (at least for the retail crowd and also for hedge funds whose “VIP” lists are littered with the same names that have driven benchmarks inexorably higher), FANG+ and Tech/Growth more generally were in what counts as free fall for a group of stocks that, until this year anyway, were basically bulletproof if you could stomach some post-earnings turmoil on occasion.

(Bloomberg)

But for all the hand-wringing, options tipped a market that was complacent or, to quote Jeff Gundlach who likes to prove he knows big words, “copacetic”. For instance, the Credit Suisse Fear Barometer (a gauge of the cost of downside protection versus upside options), dove to a fresh five-year low last week.

(Bloomberg)

The same dearth of demand for downside hedges is readily observable across similar metrics (you can read more on this from Bloomberg here, but not until you’ve finished reading this post, ok?)

“The S&P 500 put/call open interest ratio recently plunged to multi-year lows [and] a few clients have been asking how this should be interpreted”, JPMorgan’s Bram Kaplan and Marko Kolanovic write, in a note dated Monday.

I’ll save you some suspense: the ostensible lack of interest in downside hedges is due to the fact that everybody already de-leveraged, de-grossed, de-netted, de-beta’d or otherwise vomited and you don’t need to hedge against further declines in something you don’t own anymore. That’s the simple version.

If you check out the chart below, what sticks out (and even if it didn’t stick out, there are big red circles which help you focus) is that over the past 13 or so years, there’s a fleeting spike in the put/call ratio when things start looking tenuous and then a collapse during the ensuing corrections.

(JPMorgan)

Again, the explanation for that is both intuitive and straightforward.

“This happens for several reasons”, Kaplan and Kolanovic write, before listing those reasons as follows:

1. investors sell much of their cash equities, which reduces put demand (since you don’t need to hedge what you’re not long to begin with);
2. options become expensive as volatility spikes, leading some investors to short futures rather than buy puts to hedge further downside;
3. call demand increases as investors buy calls or call spreads to hedge right tail risk from being underweight or short equities; and
4. investors monetize some of their hedges (reducing put OI)

I suppose you can take some measure of comfort in all of that, assuming there’s solace to be had in knowing that the reason upside hedges are in demand more than downside protection is because everybody already sold everything and the only thing left to do now is buy some calls on the off chance Jerome Powell stops being “loco” and catalyzes a rally. Like he did on Wednesday.