In a new era of uncertainty for the stock market, traders are gearing up for potential extreme scenarios, ranging from the prospect of stocks soaring even higher to the risk of a sudden crash. As the second quarter begins with the stock market sitting at an all-time high, the options market reveals the mindset of traders.

Demand for put options, which pay off in the event of a minor correction, is currently at record lows. On the other hand, traders are quietly acquiring tail-risk hedges, offering protection should stocks swing wildly. This suggests that while Wall Street remains unconcerned about a slight slump, there is growing unease about an unpriced risk that could threaten the bull market.

Inflation continues to trend downward, and the Federal Reserve hints at potential interest rate cuts this year. As a result, rates volatility has dropped to its lowest level since February 2022, creating a favorable environment for stocks. The S&P 500 experienced a significant gain of 10% in the first quarter, its strongest start to the year since 2019. Furthermore, it notched 22 new all-time highs during the first three months of 2024.

However, as gains become more concentrated among a few key stocks, investors are searching for value in lesser-known areas of the market. Small-cap stocks appear primed for a recovery, while the tech-heavy Nasdaq 100 Index lagged behind the broader S&P 500 in the first quarter after outperforming it consistently last year. Approximately 70% or more of S&P 500 firms held above their 200-day moving averages during each session, marking the most extended period since 2021.

"The market is displaying increasing confidence in a genuine soft landing, or even no landing scenario, where overall economic growth in the US remains solid," commented Lisa Shalett, CIO at Morgan Stanley Wealth Management. "It makes sense that a broader group of companies, including those in cyclical industries like industrials, materials, and energy, can perform well."

The recent resurgence of meme stock mania has also contributed to investor confidence, as day traders flocked towards stocks and equity derivatives following the initial public offering of Reddit Inc. and the rally in Trump Media & Technology Group Corp. In fact, retail investors are demonstrating their longest stretch of bullish options market positioning since the meme stock craze of 2021, according to Citadel Securities institutional options desk data.

This growing confidence has led investors to shed defenses against a minor correction, as the cost of S&P 500 bullish call options with a 25% chance of being in the money in one year has risen, while the cost of equivalent bearish puts has decreased. These trends indicate that investors are prepared for further broad market advances and are not overly concerned about a slight pullback.

However, investors are showing increased apprehension about the occurrence of a major disaster, illustrated by a rise in positioning for a volatility spike. Average daily call volume on the Cboe Volatility Index (VIX) during the first quarter exceeded that of the previous two quarters. Additionally, the two-month skew, which measures the cost of 25-delta calls compared to equivalent puts, is currently at its highest level in five years.

Investors are less worried about typical catalysts such as valuations or earnings driving a correction, according to Cboe Global Markets Inc.'s Mandy Xu. Instead, their concerns revolve around potential black swan events that could lead to a significant spike in volatility.

One major risk factor is the timing and extent of interest rate cuts by the Federal Reserve this year. Chairman Jerome Powell recently emphasized that the central bank is not rushing to ease policy, despite inflation data aligning with expectations. Speculation about higher-for-longer rates could impact market sentiment in the upcoming quarter.

Another issue to consider is the overall performance of the broader market if the artificial intelligence darlings that have been driving the indexes suddenly falter. Barclays strategists caution that stretched positioning and technical factors might prompt a selloff, with tech shares potentially leading the decline.

Nevertheless, for now, these fears remain somewhat contained as hopes for another solid earnings season could push valuations even higher. This has led to a significant decrease in protective put options and an increasing emphasis on chasing rallies.

"Options traders appear more inclined to buy 'FOMO insurance,'" noted Steve Sosnick, Chief Strategist at Interactive Brokers, highlighting the lack of hedging at the broad market level. "But there's still a significant gap between a correction and true tail risk."

As traders brace themselves for potential extremes in the stock market, concerns about unpriced risks and the impact of interest rate cuts loom in the background. While the market remains optimistic about continued advances, the rise in volatility hedging suggests a growing awareness of potential black swan events that could upend the current bull market.