To The Moon

• Market pricing in 1-in-5 odds for 23% S&P 500 Gain in 2023
• Susquehanna advises clients to sell calls and fund put hedging

Hedging against the unknown is the name of the game in the options market. One risk that traders are increasingly attuned to in equities is the chance they will rally in 2023.

Wall Street strategists doubt it and investors are positioned against it, but certain pricing trends in derivatives show fewer traders are ruling it out after last year’s nearly 20% plunge in the S&P 500. The bets are far from the consensus — right now they’re pricing in a 1-in-5 chance the S&P 500 essentially reverses the decline in 2023, according to an analysis of implied volatility by Susquehanna International Group. But that’s a lot better odds than were being placed this time last year, when they stood at 1-in-20 for such an advance.

Contributing to demand for bullish calls is the unusual success traders had with them last year, as swift bear-market rallies paid off for investors who almost universally cut equity exposure to the bone. That positioning minimized the need for downside protection leading to an unusual situation where buying puts failed to deliver big gains even as the S&P 500 sold off. To wit, the Cboe S&P 500 Risk Reversal Index (RXM) tracking 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), which follows a strategy that holds a long position on the equity gauge while buying puts as a hedge, lost 20%.

The diverging performance reflected a brutal market where investors were even willing to pay up for bullish options, causing a rise in the relative costs of calls versus puts, a relationship known as skew.

One way to understand skew, according to RBC Capital Markets’ strategist Amy Wu Silverman, is to think of it as “a representation of tail, the ‘thing’ we are most worried about,” she wrote in a note to clients on the weekend. “The ‘thing’ we are most worried about isn’t a down-crash but an up-crash.” That has kept call prices elevated versus puts, and might be why it stays that way “for a long, long time,” she said.

So with stocks limping into 2023 and the Federal Reserve clear in its intention to keep rates elevated until inflation is well on the path lower, investors anticipating market turmoil are again paying up for options that capture upside if a rally breaks out, the analysis by Susquehanna showed.

The S&P 500 fell 0.4% to 3,824 on Tuesday. As of Friday traders were assigning a 26% probability that the index would drop below 3,500. The odds climbed to almost 1-in-2 for a rise of almost 10% to above 4,200. For the S&P 500 to go back to or above its all-time high of 4,800, the odds were 14%.

The pivot toward bullish options means investors can take advantage of the rich pricing, 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,” he wrote in a note Tuesday. “While this may not necessarily be that surprising given last year’s declines, it has meaningful implications for option pricing/implied outcomes.”