Bets on Stock Rally Explode After an Odd Year in Options Trading

Analysts Notebook wrote a column · Jan 5, 2023 04:17

Hedging against the unknown has always been the main objective in the options market. One risk traders are increasingly aware of is missing out on the potential rally in equities in 2023.

The $Cboe S&P 500 Risk Reversal Index(.RXM.US)$, which tracks a strategy of selling puts to buy a call, was up 1.5% last year, while the $Cboe S&P 500 5% Put Protection Index(.PPUT.US)$, which follows a strategy that holds a long position on the equity gauge while buying puts as a hedge, lost 20%.

Bets on Stock Rally Explode After an Odd Year in Options Trading

The diverging performance implied that investors were willing to pay an extra amount for bullish options, causing a rise in the relative costs of calls versus puts, a relationship known as skew. With stocks limping into 2023 and the Federal Reserve expected to keep rates elevated, investors anticipating market turmoil are indeed paying up for options that capture upside if a rally breaks out, the analysis by Susquehanna showed.

As of last Friday, options traders were anticipating a 26% probability that the $S&P 500 Index(.SPX.US)$ would drop below 3,500. The odds climbed to almost 50% for a rise to above 4,200. For the S&P 500 to go above its all-time high of 4,800, the odds were 14%.

The current pivot toward bullish options on the S&P 500 Index means investors can actually take advantage of the inflated pricing by selling calls to fund protective puts, according to Christopher Jacobson, a strategist at Susquehanna.

"While the current option implied likelihoods of various moves lower over the course of the year are pretty similar to how the same percentage moves looked at this time last year, the upside of the distribution is notably different now versus then," Jacobson wrote in a note Tuesday.