A Low-Risk Big Payoff on the Market Moving Higher

ETFs, Options, The Fed

We’re close to entering the final quarter of 2017, and the S&P 500 is continuing to set record highs above the 2,500 mark. So where will it be when 2018 hits? Will the record-setting highs continue? Are we going to pull back in the fourth quarter? Or, is it going to be mostly sideways action ahead?

Unfortunately, my crystal ball is broken and I can’t seem to find a complete deck of Tarot cards. What’s more, my wife gets upset when I try to read entrails on the kitchen table. So, it looks like we’re going to have to do some old fashion analysis to come up with a best guess at where the stock market is headed.

For the bulls out there, there are plenty of reasons to believe the market will continue running higher in the coming months.  Most notably, the economy is managing to do a very impressive balancing act of providing jobs and spending growth without the presence of excess inflation.

If the job market stays strong and consumers continue to spend money without the economy becoming overheated (i.e. high inflation), then interest rates won’t need to be hiked. A balance between solid economic growth and low interest rates is about as much as you can ask for from an economic standpoint.

Moreover, the current administration is very pro-business. There could be a corporate and/or personal tax break coming – something the markets tend to like. Even if no tax breaks are forthcoming (or an increase in infrastructure spending for that matter), there probably aren’t going to be any negative business policies (tax, regulatory, or otherwise) for the next three or so years.

On the other hand, there are several potential negative catalysts which could derail the current bull market. Chief among these is the threat of nuclear attack from North Korea. While it’s extremely unlikely North Korea would actually launch a nuke at a live target, the threat can still be unnerving for the financial markets.

Additionally, there is a small possibility of armed conflict with North Korea if sanctions don’t work. Any type of armed conflict could escalate into something more severe, and that’s definitely not good news for investors. Right now, the market isn’t overly concerned with the situation, but it certainly bears watching closely.

A more realistic, although less extreme concern, is what the Fed does with interest rates and its massive balance sheet moving forward. While the Fed isn’t likely to do much with rates (perhaps a small hike in December is the most the market is predicting), what happens with the balance sheet could potentially impact the markets.

There are also several potential political catalysts. Most political effects on the financial markets are short-lived. However, a major scandal could potentially create enough uncertainty to roil the markets. There’s also the fate of health care to consider, which could have wide-ranging consequences on certain sectors depending on how things play out.

So, what’s it all mean? Where’s the market headed?

Well, it doesn’t appear fundamental analysis is going to answer the question. Fortunately, that’s where options comes in.

At least one big trader is convinced the markets are going to be anywhere but here by next January. This trader purchased a large straddle in the SPDR S&P 500 ETF (NYSE: SPY), the most heavily traded ETF in the world.

Keep in mind, an options straddle is where you buy a call and a put at the same strike in the same expiration month. The idea is you make money in either direction, as long as the move is big enough to cover your costs.

This particular SPY straddle is quite expensive, so you know the trader firmly believes a big move is coming in one direction or the other. Specifically, with SPY right around $250, the trader purchased 1,000 SPY 250 straddles expiring in January of next year. The trade cost a little over $12 for the straddle, or $1.2 million in premium.

The high cost of the straddle means the breakeven points are all the way down to about $238 and up to $262. That’s about a 5% move in either direction. It’s not a huge move, but certainly more than what we’ve seen happen over most of this year.

Still, as we discussed above, there are lots of reasons to believe stocks could move a fair amount in either direction. However, you may wish to try a trade like this out for a cheaper cost.

One alternative is to purchase a $250 straddle, but at a closer date. After all, September and October tend to be the most volatile months for stocks. By November (and certainly December), investors are already turning their attention to holiday shopping.

For example, the October 27th 250 straddle in SPY costs about $5, or less than half of what the January straddle costs. You only have 5 weeks until expiration, but SPY only needs to move to $245 or $255 to break even. That seems highly plausible given all the potential catalysts out there – both positive and negative for stocks.