Traders on Friday piled into U.S. stock options contracts that would pay out if volatility jumped from the current four-year lows, even as the S&P 500 remained within striking distance of new highs.
Volume in options on the Cboe Volatility Index, which are typically used to guard against stock market gyrations, stood at 1.2 million contracts at 2:20 p.m. Friday, on pace for the highest level in about three weeks.
The index, known as “Wall Street’s fear gauge,” stood at 12.51 on Friday, just above the four-year low of 11.81 hit in late December after a searing late-year rally that helped boost the S&P 500 to a 24% gain in 2023.
With the S&P 500 less than 1% away from its January 2022 record closing high, some traders appeared to be taking advantage of relatively cheap pricing on defensive options contracts to pick up portfolio hedges.
The largest VIX trade on Friday was a $16.8 million purchase of 250,000 call options that would benefit from the volatility index rising above 17 by mid-February.
“I think it is one of the bigger VIX call purchases that we have seen in a while,” Chris Murphy, co-head of derivative strategy at Susquehanna Financial Group, said. The trade was more likely to be a defensive play taking advantage of comparatively attractive volatility levels to add portfolio protection rather than an outright wager on a drop in the stock market, Murphy said. “It’s probably a big fund that might even be leaning very long, saying this is the most attractive hedge for us right now,” he said. The strength of hedging activity on Friday was in contrast to a generally anemic level of defensive trading in recent weeks.
“Right now, oil prices have been ... leading the stocks,” said Matthew Maley, chief market strategist at Miller Tabak. “So if oil prices can break out a little bit from here, which would catch people a little off guard, this energy group is going to start playing catch up real quick.”
Strategists at the Wells Fargo Investment Institute (WFII) this week upgraded their rating on the energy sector to “favorable” from “neutral,” saying “oil prices will bottom with the global economy and then finish the year higher.”
A potential rise in Middle East tensions and any OPEC actions on production are factors that could influence near-term oil prices.
Prices for U.S. crude jumped as much as 4.5% on Friday before settling up 0.9%, after several oil tankers diverted course from the Red Sea following overnight air and sea strikes by the United States and Britain on Houthi targets in Yemen. The energy sector ended up 1.3% on the day.
“While a resolution of the problems in the Red Sea would be bearish for oil, it appears as though the situation is escalating and the risk should drive oil prices higher,” wrote Mike O’Rourke, chief market strategist at JonesTrading.
Another key factor for the group will be upcoming quarterly earnings reports. Oil services firm SLB, formerly called Schlumberger, reports next week, with Baker Hughes and Marathon Petroleum among those expected later in the month.
Energy is expected to post the worst full-year 2023 earnings performance of any sector, falling nearly 26% overall, LSEG data showed. But its earnings are expected to increase 1.6% in 2024.
Improving earnings trends and enticing valuations are among the factors supporting energy shares along with the potential for the group to be a hedge should geopolitical tensions rise, said Walter Todd, chief investment officer at Greenwood Capital. The firm is overweight energy in its portfolios, including shares of Conocophillips and Chevron.
While energy earnings are improving, the sector’s estimated performance this year is still expected to trail the 11.1% increase for the overall S&P 500 in 2024.