Hedging demand hits a 15-month high—Is the US stock market rebound nearing its end?

Traders' concerns about whether this year's stock market rally can continue are intensifying. Although the S&P 500 Index remains up more than 12% this year, investors are sparing no expense to lock in gains, especially in the technology sector. The cost of options on the Invesco QQQ Trust ETF relative to the SPDR S&P 500 ETF Trust has risen to its highest level since August 2024, indicating a clear rise in market hedging sentiment.

The S&P 500 Index just posted its biggest weekly trading range since June. Nvidia’s impressive earnings and Jensen Huang’s assurance that artificial intelligence is not a bubble failed to ease investor anxiety. Meanwhile, Bitcoin has fallen by about one-third since hitting its all-time high last month, and worries about the pace of Fed rate cuts are mounting.

Tech stocks were particularly volatile last Thursday. Nvidia’s post-earnings gains in early trading quickly reversed, and that day saw the sharpest swings since April 8. The VIX fear index closed at its highest level since April, highlighting market nervousness.

The surge in tech stock hedging costs reflects investors' worries about an AI bubble and weakening retail bullish sentiment triggering selloffs, with the sustainability of capital expenditures becoming a major focus.

Volatility Premium Remains Elevated

The risk premium between implied volatility and realized volatility remains relatively high. Asym 500 Founder Rocky Fishman noted that the six-month VIX premium relative to the S&P 500’s six-month realized volatility is at an exceptionally elevated historical level.

Vuk Vukovic, Chief Investment Officer of hedge fund Oraclum Capital, remains active in the short-term options market. He said last Thursday's market stress moments "benefit us, because when you buy volatility and volatility erupts, you get the highest returns." He joked last Friday:

"Anyone who bought put options at the peak yesterday could retire today."

Vukovic pointed out that option sellers only entered the market last Friday, driving the VIX lower. He expects volatility will contract again before Christmas, but forecasts one more spike before year end.

Tech Stocks and Bitcoin Linkage Intensifies

The recent decline in tech stocks coincided with Bitcoin's plunge, and the sensitivity between the latter and the Nasdaq 100 Index has risen in recent weeks. Vukovic said, "The correlation with leveraged Nasdaq is very high," referring to funds such as the ProShares UltraPro QQQ ETF. Wall Street options traders now see Bitcoin as a pure risk asset, rather than a tool to hedge market volatility as it was once considered.

Similar to QQQ, the put skew for iShares Bitcoin Trust ETF has also increased, reflecting rising costs to hedge against declines and signaling investor fears of a larger drop. This fund, ticker IBIT, has attracted over $27.6 billion in inflows this year, but saw nearly $2.2 billion in outflows in November.

Last Friday, an investor bought $43 put options and sold $52 call options on the ETF to raise funds, a position that hedges against the risk of Bitcoin breaking below early April lows. This so-called risk reversal strategy allows traders to sell 10 million shares of IBIT over the next four weeks if there is another 9% decline, but faces the risk of being forced to short in the event of a rebound.

The Riddle Behind the Selloff

Barclays equity derivatives strategist Stefano Pascale and others described the current pullback as "fairly restrained," but found it "a bit perplexing" given the resilience of economic data and strong corporate earnings, especially from large technology companies. In last week's report, they concluded that concerns about an AI bubble and weakening retail bullish sentiment caused the selloff, with particular emphasis on worries about capital expenditures.

Later last week, some traders began to cash out positions betting on higher volatility, which often happens after sharp price swings. According to market participants, more than 250,000 VIX December 25/30 call spreads were sold last Thursday and Friday. According to open interest data, these trades appear to have closed positions established in early November.

Former Goldman Sachs strategist Fishman said in an interview:

"I don't think people are rushing to unwind hedges; otherwise, there wouldn’t be such a large volatility risk premium. I think that among those cashing out hedges, some may be simultaneously adding more protection."

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