It’s the question every investor wants answered: where are stocks headed next? Can we count on a sustained rise? Or is it time for some froth to come out of the market? Market volatility has been as low as it’s ever been in recent memory. It certainly feels like something big could happen. Of course, no one knows when or what direction this big move could take. And therein lies the rub.
It’s never easy trading in this situation, where stocks could soar higher or plunge lower with what seems like equal probability. So how do we trade in this scenario?
First off, we need to take into account what stocks have done recently – namely, an 8% increase over the last quarter. Now, as you know, past performance is never a guarantee, of well, anything. But, in this case, it’s important to understand why stocks have been on such a tear.
Investors became very bullish after the election because the new administration was expected to be more business-friendly. They promised to repeal a host of regulations, while also spending a pile of money on infrastructure.
After the initial surge, stock prices have hit something of a holding pattern, as investors question whether the administration will actually push ahead with its promises. Although, it appears likely certain regulations are going to come off the books.
For the last several weeks, major indexes have basically flatlined. This has been true despite a strong earnings season so far. In fact, according to Bloomberg, sales and earnings are rising at the second-fastest pace since 2012. After a multi-year recession in earnings growth, we’re finally starting to see something of a reversal.
Yet, this has had little to no effect on the overall market. Check out the chart:
You can see the huge spike in the S&P 500 index after the election. However, since mid-December the index has turned into a slow crawler. While the general direction has been up, daily moves above 1% have been non-existent. With so little volatility, but consistent daily volume, it’s become very difficult to predict what’s in store.
On one hand, investors don’t want to be on the sidelines if stocks are set to spring into another strong bull market. On the other hand, so little movement could also be the prelude to a pronounced selloff, in other words, the calm before the storm.
With stocks and ETFs alone, this scenario is very difficult to trade. Fortunately, it’s really not a big deal to trade using options.
I’ve mentioned trading straddles in the past. That’s where you’d buy the at-the-money (ATM) call and put in a stock or index in hopes of a big move in either direction. However, I would not use a straddle in this scenario. Time decay (options premium declining as we approach expiration) would destroy your straddle value if we continue this do-nothing trend for the next several weeks.
Instead, I’d use a strategy to take advantage of stock gains, while preparing for a spike in volatility as a hedge. Let’s use the SPDR S&P 500 ETF (NYSE: SPY) as our proxy for the overall market. I want to be long SPY, but also long S&P 500 Volatility Index (VIX). The VIX is the most popular measure of investor fear and overall market volatility.
This two-pronged strategy gives us the opportunity to make money on the upside, while preparing for the possibility of a big downside move. SPY options are cheap right now with volatility so low. And, VIX options hold their value until the very end because they are often used for hedging. It’s a safer bet than using a SPY straddle.
In this case, we could buy the SPY March 230 calls for just over $3.00. SPY is trading around $230.50, so it’s essentially the at-the-money call. Breakeven for this trade is just $233. That’s only about a 1% move to get to breakeven…in over a month. Hard to argue with the value.
At the same time, we can buy calls spread in VIX. Keep in mind, as volatility rises, VIX goes higher (and usually the SPY moves in the opposite direction). As cheap as the VIX is right now (under $11 as of this writing), the options are still expensive relative to SPY options. That’s why we’ll use a call spread instead of straight calls.
Let’s go a bit out of the money (OTM) for our VIX call spread. Volatility moves very fast when it rises, so we can look at cheaper, OTM options for this spread. The March 13-19 call spread (buying the 13 call and selling the 19 call at the same time) only costs around $1. That means if VIX goes to $19, you’d make $5 in profit (the distance of the spread or $6 minus the cost or $1).
Putting it all together, you can add the $1 cost of the hedge to your breakeven point for the SPY calls. That means if SPY goes to $234 ($230 stock price + $3 SPY call premium + $1 VIX call spread premium) by mid-March, you reach breakeven. Above that, your profit is unlimited to the upside. Remember, that’s not even 1.5% higher than current levels.
If the market does nothing before March expiration, you’d lose the $4 in premiums from your SPY call ($3) and VIX call spread ($1). On the other hand, if the market plunges and VIX spikes to 19 or above, you’d collect $2 in profit (distance of spread or $6 minus $4 premium cost from both the SPY and VIX call spread). That’s not bad for a worse-case scenario.
To recap, with this strategy you make money over the next five weeks if SPY climbs over 1.5%. If the market takes a dive, you’ll also make money. If the market does nothing, you lose your premium. Of course, there are various payout scenarios in between. Ultimately, if you think there’s going to be some action in the next month, this strategy makes a lot of sense.