Investors are afraid. How to use their fears to profit from them.
Fear is all the rage again.
It’s hard to be definitive on anything in such an erratic environment, but the latest variant of Covid, coupled with the realization that the Federal Reserve’s easy money policies could end sooner than expected, rocked stocks and raised fear premiums in the options market.
The market fear indicator â the
Cboe volatility index,
or VIX – seemed stuck at a drowsy level, as if to suggest that investors forgot that stock prices sometimes go down. It has exploded in recent weeks.
The VIX was around 15 at the end of October and recently peaked around 32. Some strategists argue that a level of 30 in the VIX signals fears of an economic recession.
In his testimony to the Senate Banking Committee on Tuesday, Fed Chairman Jerome Powell said it was time for the bank to stop calling inflation a transient phenomenon. The stock market sank in response and the VIX surged, although it has since reversed some of the movement.
The VIX wanderings will be talked about a lot, but we know this: Investors who have long shunned puts are now buying them to hedge their portfolios. The trend started in August, even as stock prices continued to climb. Still, it took the emergence of the Omicron variant – and Powell’s apparent recognition that inflation might not fade so quickly – to firmly change investor sentiment.
The sudden demand for put options, the value of which increases as stock prices fall, helped redefine an odd market dynamic that characterized much of the year.
As stock prices continued to rise higher, premiums on call options also tended to rise. The rush to buy calls, the value of which increases as stock prices rise, has made bullish calls often more expensive than bearish puts.
The opposite is generally the case.
Returning to normal market dynamics is, at least for now, an opportunity for anyone who uses options to navigate the stock market. For investors who want to buy stocks when they are weak, high sales premiums may seem attractive. By selling a guaranteed cash put option, investors can be paid by the options market for agreeing to buy a stock at a lower price.
The put-sale approach works best for investors who have strong beliefs in a stock and a long enough horizon to overcome short-term volatility.
We have always advised investors to consider writing puts options on blue-chip, dividend-paying stocks that can be held for three to five years. Now, however, it makes sense to be more nuanced. It’s hard to have any clarity around the Omicron variant or even the actions of the Fed.
Aggressive investors looking for an opportunity to trade should consider sticking to options that expire before the Fed concludes its next meeting on December 15. It is unclear how the market will react to more hawkish comments about rates and the cut, or even the lack of such comments.
For those who can’t wait, and for those who still love to trade, consider selling puts that expire on December 10th. A possible vehicle: the
Select Sector SPDR technology
exchange-traded fund (ticker: XLK), which includes many large technology companies that could be viewed as safe havens in uncertain times.
With the ETF at $ 166.41, aggressive investors could sell the December $ 161 put option that expires on December 10 for around $ 1.50.
Once the Fed concludes its meeting and the fog dissipates in the market somewhat, the position may be reset depending on changing market dynamics, which are surreal enough to have inspired Salvador DalÃ.
Steven M. Sears is President and Chief Operating Officer of Options Solutions, an asset management company. Neither he nor the company has a position in the options or underlying securities mentioned in this column.
E-mail: [email protected]