Put options on the S&P 500 offer better protection than Nvidia-based hedges against earnings risk, BofA Global Research says
An early August rout in the U.S. stock market and the Federal Reserve's economic symposium in Jackson Hole, Wyo., last week have stolen the spotlight from Nvidia Corp.'s upcoming earnings. Investors used to the company's blockbuster results may underprice the risk of a disappointment and its impact on the broader market, according to BofA Global Research.
"Don't sleep on Nvidia's earnings, [which are] a consistent driver of the S&P 500 returns and still a risk to markets if they disappoint," a team of BofA Global analysts led by Gonzalo Asis, an equity-linked analyst, said in a Sunday note.
The quarterly earnings results for Nvidia $(NVDA)$, the poster child of the artificial-intelligence theme, have been a key driver of short-term stock-market performance since January 2023, Asis and his team said. The chart below shows that the reaction of Nvidia's stock to earnings is highly correlated with the S&P 500's SPX performance in the two weeks following the release.
R-squared measures the extent of an index's price movements that can be explained by movements of a security or other variables. A value of 1 implies that all the price changes of one variable could be explained by the second variable, while a value of 0 suggests that there's no correlation between the two variables.
Nvidia is expected to report its second-quarter earnings results after the market closes on Wednesday afternoon. Concerns have intensified about the state of the AI boom that has propelled megacap technology stocks and the broader market for nearly two years.
Shares of Nvidia have surged over 150% so far in 2024, while the S&P 500 was up nearly 18% in the same period, according to FactSet data. Nvidia's stock has contributed around 5 percentage points to the large-cap benchmark index's year-to-date returns, the BofA analysts said.
What if Nvidia misses earnings?
To hedge against disappointing earnings and the potential impact on the broader stock market, Asis and his team said it is "more attractive" to buy put options on the S&P 500 than on Nvidia's stock itself.
Put options give investors the right, but not the obligation, to sell a specified amount of an underlying security at a predetermined price within a specified time frame. They can be used to hedge a stock or an index, since put options become more valuable as the price of the underlying security falls.
Options trading betting on Nvidia's stock now implies a 10% move after the company posts earnings results on Wednesday, but history shows the stock hasn't sold off more than 8% on the day of reporting since 2018, Asis and his team said.
Meanwhile, the sudden surge of Wall Street's closely watched "fear gauge," the Cboe Volatility Index VIX, earlier this month highlights the return of fragility for the broader market, but the S&P 500 has "often remained fragile after such large shocks," the BofA analysts said.
The VIX has been in a freefall after peaking above 65 on Aug. 5. It has fallen more than 75% since then to remain well below its long-term average of 20 as of Monday afternoon, according to Dow Jones Market Data.
"The fastest VIX retracement ever offers a chance to load on S&P-based hedges after this recent sharp rally," the analysts said.
Besides hedging the aftermath of Nvidia's earnings, Asis and his team said the put options on the S&P 500 could offer protection from upcoming "macro drivers" such as "another broad market fragility shock," the August nonfarm-payrolls report and the release of the U.S. manufacturing PMI next week.
In addition, the S&P 500's options are cheap relative to Nvidia's options compared with past earnings seasons (see chart below).
"S&P options still offer a historically attractive entry point to hedge [Nvidia] earnings," Asis and his team said on Sunday.
U.S. stocks were mostly lower on Monday afternoon as investors appeared to be rotating out of the tech sector ahead of Nvidia's earnings on Wednesday and the personal consumption expenditures price index on Friday.
The Dow Jones Industrial Average DJIA was edging up after rising to a new intraday record in the morning session, while the S&P 500 was off 0.2% and the Nasdaq Composite COMP was falling 0.8%, according to FactSet data.