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Who's Hedged? Seriously, Who's Hedged?

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Stocks in this article: SPY

A colleague forwarded some comments made by a Goldman Sachs analyst who was pointing out the impressive million-contract-per day average volume for S&P 500 (SPX) index options this month has come with unusually flat Put-Call skew and a steadily declining put/call volume ratio in the product, which is typically where the largest institutional money manager go to hedge.

 

SPX Daily Put/Call Ratio
Source: Trade Alert

 

Indexes were my primary focus for the first 10 years of my trading career, which meant most of the time big funds came to me to buy puts when they were concerned about a downside move, and often sell calls as an overlay to enhance yield. While plenty of other trading activity takes place in the index, this undercurrent of put buyers and call sellers has tended to persist year in and year out, and many believe it's the primary reason the put/call skew exists as a 'smirk' with a higher downside level than upside at similar moneyness. This flow also means the predominant position held by most sell-side broker-dealers in the index is a short-put/long-call one- which is great as the market climbs and makes for an ugly scenario in a market crash (fortunately the market goes up more often than it crashes, right?).

When I'd occasionally lose sleep because of downside risk on our books, one of the smartest index traders I knew (and the youngest managing director ever named at Salomon Brothers) used to tell me to 'Relax, the puts you are short are the reason fund managers won't dump their positions into a downward move.' Basically suggesting that a hedged market is unlikely to crash. While I readily admit this argument was partly to justify our level of risk (and collection of theta), I do believe there is validity to it, and that's why today's unusually flat SPX vol skew and relatively low put open interest (compared to call OI) tells me that we might be in for a serious pullback.

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