An options strategy that would pay off if stocks see a sharp move in either direction is pricing in the biggest Fed-day move since March 2023
Some options traders are leaving nothing to chance ahead of Wednesday's Federal Reserve policy meeting.
The price of a strategy that would pay off if stocks see a sharp swing in either direction on "Fed day" has risen to its highest level since the run-up to the central bank's March 2023 meeting. Back then, investors were on tenterhooks following the collapse of Silicon Valley Bank.
The increase reflects the fact that traders have been unable to agree on the size of the interest-rate cut expected by the Fed, as interest-rate futures have seesawed back and forth over the past few sessions.
Analysts at Bank of America have said the degree of uncertainty expressed by markets is the highest they have seen dating back to at least 2015. Many have said the lingering doubts have little precedent in recent memory ahead of a major Fed policy decision.
Traders who purchased an at-the-money call and an at-the-money put on the S&P 500 SPX - a strategy known as an at-the-money straddle - would need to a see a swing of 1.2% up or down for the play to be profitable, according to Citi.
An at-the-money option has a strike price that is roughly on par with where the underlying stock or index was trading at the time the contract was purchased.
The uncertainty has helped boost demand for hedges, Citi strategists said.
Wednesday's session is expected to be the second-most volatile before the end of 2024. Only Nov. 6 - the day after the Nov. 5 presidential election - is expected to see bigger stock-market swings, according to options-pricing data cited by Citi.
While a rate cut on Wednesday has long been considered a virtual certainty by the market, interest-rate futures traders have wavered on the issue of just how big the cut will be.
As of Monday afternoon, they were leaning toward a 50-basis-point cut as the most likely scenario, according to data from the CME Group.
Traders see scope for volatility beyond Wednesday
To be sure, there are signs that investors remain apprehensive about potential stock-market volatility beyond Wednesday.
Demand for insurance against a steep market selloff has remained robust, even as stocks have rebounded from bouts of turbulence that rattled investors in early August and September.
Although the S&P 500 was trading near record territory on Monday, so-called put skews showed investors have continued to pay up for downside protection, as depicted in the chart below.
Put skew is an options-market metric that measures the relative cost of contracts that would protect against a steeper decline in the underlying index or stock.
To be sure, another gauge of investors' near-term anxieties was looking more subdued. The Cboe Volatility Index VIX, known as the VIX or Wall Street's "fear gauge," stood at 17 on Monday. That's below its long-term average and well below its early August closing high north of 38.
But at the same time, the VVIX index, which measures demand for hedges tied to the VIX, has lingered north of 100, suggesting that demand for crash protection has remained "sticky," according to Amy Wu Silverman, managing director and head of derivatives strategy at RBC.
Investors have struggled to parse how markets might react on Wednesday, given the uncertainty around the size of the rate cut.
Some suspect investors could be disappointed no matter what the Fed decides.
"A 50-bps cut likely indicates rising expectations for a weaker economy, while 25 bps may be negatively received by the market, given the recentmove in fed futures," Citi strategists said in a note shared with MarketWatch.
Ultimately, the Citi team expects the market's reaction will depend on what Powell says, as well as the details laid out in the latest batch of economic projections released by the Fed.
More challenges for markets await shortly after the decision. On Friday, options linked to individual stocks, ETFs and indexes will expire, alongside index futures. The quarterly occurrence is known in derivatives markets as "triple witching" and has often preceded a jump in volatility.
Pre-Fed 'everything rally' faces its first challenge
Since the start of the third quarter, traders across markets have placed bets on stocks, bonds, gold and currencies that would pay off if the Fed aggressively lowers interest rates.
In the U.S. stock market, defensive sectors like utilities, consumer staples and real estate have been the top performers since the start of July, according to FactSet data.
In the Treasury market, yields across the curve have fallen dramatically. Recently, this caused the spread between the 2-year BX:TMUBMUSD02Y and 10-year Treasury yields BX:TMUBMUSD10Y to return to positive territory for the first time in two years.
Meanwhile, gold (GC00) has climbed to record highs, while the U.S. dollar DXY has rapidly weakened against major rivals like the Japanese yen $(USDJPY.FOREX)$, as well as emerging-market currencies like the Mexican peso $(USDMXN.FOREX)$ and South Korean won $(USDKRW.FOREX)$.
Last week saw virtually all corners of the stock market rally in tandem. The Nasdaq Composite COMP led the way as Big Tech and semiconductor stocks came roaring back. But the small-cap Russell 2000 RUT also gained more than 4%, according to FactSet data.
"There seems to be a bit of an 'everything rally' going into this, hoping for a full-blown dovish tilt in terms of the cuts and the outlook," said Matthew Miskin, co-chief investment strategist at John Hancock, during an interview with MarketWatch.
That could change once rates start to come down, especially if investors determine that they have once again misjudged how quickly the Fed intends to lower borrowing costs.
Miskin likened such a scenario to the broad-based rally that gripped stocks in November and December as traders bet that the Fed would cut rates aggressively in 2024.
Back then, small caps and other lagging corners of the market burst higher, but their gains were short-lived. As a resurgence in inflation pushed investors to dial back their rate-cut hopes, the broad rally faded and Big Tech reasserted its dominance.
Fed-funds futures are pricing in more than 200 basis points of easing between Wednesday and the end of 2025, according to CME Group data. Many on Wall Street, including Miskin, believe such steep cuts would be excessive, unless the U.S. slides into a recession.
Of course, a more painful economic downturn would present its own challenges for markets, Miskin added.
Stocks finished mostly higher on Monday, with the Dow Jones Industrial Average DJIA booking a fresh record close, its 27th of 2024, according to Dow Jones Market Data. The blue-chip average gained 228.30 points, or 0.6%, to finish at 41,622.08.
The S&P 500 SPX gained 7.07 points, or 0.1%, to finish at 5,633.09. Meanwhile, the Nasdaq Composite retreated, falling 91.85 points, or 0.5%, to 17,592.13.
