The end of super-cheap money from the Federal Reserve is trumping corporate earnings results as a key risk to hedge for stock investors.
Investors are looking forward to fewer price gyrations during this earnings season but are worried about how withdrawal of the Fed's extraordinary monetary support, expected in June, will affect shares.
Normally the earnings reporting period is prone to ups and downs, but strong profit growth should keep volatility subdued.
That's lessened the cost of hedging risk, and some investors have identified the end of the Fed's quantitative easing effort as something to hedge against. Some are willing to pay more to protect against declines a couple months down the road.
It looks like all the markets from equities to currencies are pricing in some sort of the continuation of the Fed's quantitative easing policies, said Joe Cusick, senior market analyst at Chicago-based brokerage firm optionsXpress.
While that gets debated between now and June, we are going to see some potential for renewed short-term volatility, Cusick said.
Aluminum maker Alcoa Inc
Investors will be scrutinizing early reports to get a clue of the sentiment for future earnings guidance and the economic landscape for the last two quarters of the year.
The prospect of good earnings in a period of still-low interest rates is supporting equities, even as the European debt crisis, higher crude oil prices, and other events overseas add some earnings risk longer-term, said WhatsTrading.com options strategist Frederic Ruffy.
The Chicago Board Options Exchange Volatility Index, a barometer of investor anxiety known as the VIX <.VIX>, is at relatively low levels. It also indicates S&P 500 index <.SPX> options are getting cheaper in the near term.
The 10-day historical volatility for the SPX dropped below 7 percent on Thursday, a sign of very calm markets, compared to 19 percent two weeks ago.
The VIX was lately trading at around the 17 level, after rising to 31.28 on March 16 in the aftermath of the Japanese earthquake crisis.
With the stock market near two-and-a-half year highs, in-line earnings may not be rewarded as they have been in past earnings cycles and could lead to disappointment.
Still, the expectation of gradual tightening of Fed policy is potentially more worrying. The Fed is in the middle of a $600 billion bond-buying program that has been credited with helping to underpin the stock market's rally. Investors are starting to buy protection against future headline risk as a result.
VIX futures are pricing in some fear in the back months. Contracts from June to November expect the VIX to rise to above a 21 to 24 reading in the second half of the year.
Near-term options as measured by the VIX are getting less expensive but we see buying demand for further out-of-the money puts in the SPX as a hedging tool, said Chris McKhann, an analyst at stock and options website optionMonster.com.
This is also reflected in the CBOE SKEW Index, <.SKEWX> which measures demand for out-of-the-money puts compared to out-of-the-money calls, McKhann said. The greater the skew, the more investors are willing to pay for the out-of-the-money protective put positions than the upside call positions.
This means those seeking protection for the downside in equities are likely best served by buying near-term at-the-money put options, which are relatively cheap and selling out-of-the-money puts--taking advantage of that skew, McKhann said.
(Reporting by Doris Frankel; Editing by Andrew Hay)