For more than a year, dealers in the U.S. equity derivatives market have noted a widening gap in the price of certain options. If you want to buy a put to protect against losses in the Standard & Poor’s 500 Index, often you’ll pay twice as much as you would for a bullish call betting on gains.
New research suggests the divergence is a consequence of financial institutions hoarding insurance against declines in stocks.
The pricing anomaly is visible in a value known as skew that measures how much it costs to buy bearish options relative to those that appreciate when shares rise. In 2015, contracts betting on a 10 percent S&P 500 decline by February have traded at prices averaging 110 percent more than their bullish counterparts. That compares with a mean premium of 68 percent since the start of 2005, according to data compiled by Bloomberg.
While various explanations exist including simply nervousness following a six-year bull market, Deutsche Bank AG says in a Dec. 6 research report that the likeliest explanation may be that demand is being created for downside protection among banks that are subject to stress test evaluations by federal regulators. In short, financial institutions are either hoarding puts or leaving places for them in their models should markets turn turbulent.
“Since so many banking institutions are facing these stress tests, the types of protection that help banks do well in these scenarios obtain extra value,” said Rocky Fishman, an equity derivatives strategist at Deutsche Bank. “The way the marketplace has compensated for that is by driving up S&P skew.”
The Federal Reserve’s Comprehensive Capital Analysis & Review, or CCAR, has become one of the most important annual events for the largest banks. It determines whether trading units, including equity derivatives, can handle a market shock and pay out capital to shareholders. In the test, banks must demonstrate that they can weather a crisis and stay above minimum capital ratios even as their amount of equity is reduced by losses and the planned dividends and buybacks.
One aspect of the stress test is gauging how banks respond to what’s the Fed describes as a “severely adverse” scenario. It’s the most extreme of three situations laid out by the central bank during the annual CCAR.
“One of the reasons S&P puts have been so expensive relative to at-the-money options this year is that the severely adverse scenario prescribed by CCAR program implies a very negative shock to the S&P,” said Fishman. “It creates value for the downside options.”
The structural shift in the price of bearish options has been debated on Wall Street for months. Another explanation has focused on the firms that supply them and the possibility that regulations such as the Dodd-Frank Act have limited market making. While banks have largely ceded their market-making role on equity exchanges to automated traders, they’re still among the biggest suppliers of stock hedges.
While stress tests are cause for hedging, there are other more imminent threats to the bull market spurring people to protect gains, according to Michael Antonelli of Robert W. Baird & Co.
“A lot of people have looked at crude, valuations and projections for earnings and come to the conclusion that it’s probably a good idea to protect to the downside,” said Michael Antonelli, an institutional equity sales trader and managing director at Robert W. Baird & Co. in Milwaukee. “Peoples’ views are definitely negatively tilted when it comes to 2016. They’re very cautious and concerned about the bull market continuing.”
Crude oil prices sit at the lowest since 2009 amid a 65 percent plunge in the resource starting in mid-2014. Meanwhile, the S&P 500 is trading at 18 times earnings, close to the highest in five years, after the gauge tripled during the bull market. Adding to bearish sentiment are corporate profits that are forecast to contract 5.6 percent in the fourth quarter, which would mark the index’s third straight period without earnings growth.
Still, the Fed stress tests remain the cornerstone of the U.S. central bank’s efforts to prevent a repeat of the 2008 financial crisis and to gauge the ability of banks to withstand economic turmoil. To Dan Deming of KKM Financial LLC, their presence will have a lasting effect on risk tolerance.
“Risk requirements have ramped up to a point where market participants are forced to buy downside puts as an insurance policy against open option positions,” said Deming. “What was perceived as reasonable risk five years ago is no longer seen as reasonable amid all the new requirements.”