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One gauge of equity volatility, the CBOE’s Volatility Index, briefly hit its highest level since October 2020 on Monday, and options activity on the index boomed.Spencer Platt/Getty Images

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Investors are racing to protect their portfolios from damage as volatility sweeps across Wall Street, sending stocks flying higher and lower as traders brace for tighter policy from the U.S. Federal Reserve Board.

Put options contracts, which can shield against losses from declines in share prices, were in heavy demand at the start of the week, when the S&P 500 benchmark index of U.S. stocks registered a 10 per cent drop from recent highs.

Traders bought 31.3-million equity put options contracts that day, Bloomberg LP data show, just shy of the all-time high set on Fri. Jan. 21, when 32.3-million of the contracts were bought. Both days far surpassed the previous record of 26.7-million contracts set in February 2020 when the COVID-19 pandemic began to rattle U.S. financial markets.

The rapid pick-up in hedging activity reflects the markedly more nervous mood among investors at the start of 2022 as the Fed prepares to cut back the stimulus it has pumped into the financial system since the pandemic struck.

“One key theme that has emerged in the first few weeks of the year is the reappearance of hedging activity,” says Amy Wu Silverman, an options strategist at Royal Bank of Canada in New York. “Outside of the general uncertainty we see as the Fed begins to move, I think there are more [tail risks] that exist this year.”

On Monday, the S&P 500 fell more than 10 per cent from its record briefly, known as a correction, and ended up closing the day higher, registering its biggest intraday move since March 2020 as the market shifted violently. However, it turned again on Tuesday morning, with the Nasdaq Composite sliding about 2 per cent. Markets, which for months have wrestled with the looming shift in Fed policy, have also begun to grapple with geopolitical tensions in Russia and Ukraine, as well as the effect the Omicron variant will have on global growth.

Data from Cboe Global Markets indicate that US$53.7-billion of options traded in the U.S. on Monday compared with the monthly daily average of US$25.3-billion.

In part, that shows how far the options market – previously the preserve of professional traders – has changed in recent months.

Trading in these contracts has surged over the past year as new retail investors have swarmed to the contracts in the wake of the meme stock free-for-all that drew millions of people to U.S. financial markets. But while many of those new day traders had been drawn to equity call options – bets that a stock will rise – since late last year, they have increasingly dabbled with puts.

That activity has ballooned since tech stocks peaked in November when Fed officials signalled their intention to tighten monetary policy. The Nasdaq Composite has fallen 15 per cent from its all-time high, with thousands of stocks in the index down more than 20 per cent.

Traders said they were watching to see how many of the newly purchased equity put contracts remained outstanding after Monday, given some investors have previously bought and quickly sold the contracts on the same day in an effort to profit on the change in the price of the derivatives.

Jason Hedberg, UBS Group AG’s global head of equity derivatives sales, estimates that outstanding interest in put options linked to one popular exchange-traded fund – Invesco Ltd.’s US$187-billion QQQ Index ETF fund QQC-F-T, which tracks the Nasdaq 100 stock index – was roughly in line with the average registered over the past few years even as put trading volumes had climbed.

“What it tells me is that there isn’t a ton of protection in place,” he says. “[That] leaves everyone a bit more exposed as the sell-offs continue.”

One gauge of equity volatility, the Chicago Board Options Exchange’s (CBOE) Volatility Index (VIX), briefly hit its highest level since October 2020 on Monday and options activity on the index boomed. The CBOE, the U.S.’s largest options exchange, reported a total of 61.4-million contracts traded on U.S. markets on Monday, more than 60 per cent above recent averages. Calls and puts trading were at similar volumes, it added.

Brian Bost, co-head of equities derivatives in the Americas at Barclays PLC, says that “for the first time in a long time,” some institutional investors had sought to reduce their exposures to stocks instead of simply rotating between sectors given the recent slide in the market.

“There is an element when volatility becomes unhealthy, when risk transfer becomes very difficult and the drawdowns that some of these funds are taking will ultimately lead towards less activity and we’re around those inflection points,” he says. “I am sleeping a little less at night.”

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