Introduction

(Bloomberg) — The S&P 500 Index’s surprise 16% rally this year is rewarding traders who bought in early and punishing those who’ve remained skeptical. But fear of a downturn remains.

Fear of Downturn Reflects in Options Market

• Contracts betting on a 10% decline in the SPDR S&P 500 ETF cost 1.8 times more than options that profit from a 10% rally.
• Investors are paying up for protection ahead of the crucial reading on US consumer prices.

Uncertainty Surrounding Interest Rates

Scott Ladner, chief investment officer at Horizon Investments, believes that the next big leg of the equity rally won’t come until there is certainty on the direction of rates.

Recent Market Performance

• S&P 500 has posted losses in four of the past six weeks, dropping almost 3%.
• Deepening economic troubles in Europe and China contribute to the market’s instability.
• The latest CPI report is expected to show a 3.6% annual increase in inflation.

Expectations for Future Rate Hikes

Traders anticipate the Fed to keep borrowing costs steady in September but also expect another rate hike before the end of the year.

Hedging Challenges in a Strong Market

Hedging has been a losing strategy due to the market’s strength and lack of significant drops for months.

Traders have experienced hedging fatigue and are reluctant to spend money on downside protection.

Picking Up Cheap Protection

Traders who believe the low volatility won’t last are taking advantage of the calm to purchase protection at a low cost.

Predicting Volatility in September

Goldman Sachs remains neutral on selling put options tied to the S&P 500 as volatility tends to increase in September.

The end of summer may mark a low point for the CBOE volatility index (VIX) which has remained below its long-term average.

A Defiance of Wall Street Expectations

The S&P 500’s advance this year has defied Wall Street’s consensus expectations for losses.

Inflation has eased while the economy has remained relatively resilient.