Option market sees a 6% chance S&P 500 drops 10% over next 3 months

The option market is currently signaling a relatively low probability of a significant downturn for the S&P 500 over the next quarter, according to Piper Sandler.

The investment bank estimates a 6% chance of the index falling by 10% within the next three months. While this figure may seem elevated, Piper Sandler suggests it could be even lower at around 5%.

"The so-called risk-neutral distribution (the shaded region) implies about 6% odds on a 10% net swoon in 3 months," they wrote. "Based on an extension of this method, the probability should be 5% (green)."

However, the firm highlights what they see as a more pressing concern: the market appears to be overly optimistic about upside potential. Piper Sandler believes the market is assigning an excessive probability of a 10% increase in the S&P 500.

"The market assigns about 3% odds to a 10% further increase in the S&P, compared to the 'fair probability' of 1%," Piper Sandler noted.

The analysts caution that this overvaluation of upside potential could lead to a correction in the market over time.