In an environment where investors grapple with the fear of missing out on further equity gains while simultaneously worrying about accumulating geopolitical risks, they may find guidance from the derivatives strategists at Wall Street's major banks. Trading strategies designed to address some of last year's most significant market contradictions remain highly relevant, with the foremost being those centered on the impact of former President Donald Trump's unpredictable policies. These uncertainties include his threats to the Federal Reserve's independence, rhetoric about military action against Iran, the proposition to acquire Greenland, and interventions in the power market. The prevailing market view is that a scenario combining rising volatility with climbing stock prices will persist into 2026, as momentum trading is severely challenged by doubts over excessive valuations, particularly within artificial intelligence (AI)-related stocks. Bloomberg Intelligence Chief Global Derivatives Strategist Tanvir Sandhu stated, "AI momentum, coupled with the US government as a source of volatility, creates a favorable backdrop for the market. While earnings growth, cyclical recovery, and AI adoption fuel right-tail risks, market fragility and high-risk policies exacerbate instability, potentially supporting a pattern where both the S&P 500 and volatility rise concurrently."
To capitalize on volatility shifts and headline risks, strategists are heavily promoting a range of strategies, from conventional tail-risk hedging to customised divergence baskets. "Magnificent Seven" Palladium Structures Mega-cap tech stocks are still expected to lead the market higher, but options on the "Magnificent Seven" are not cheap. Barclays strategists argue that directly buying call options is not cost-effective, favoring instead the so-called Palladium structure—a strategy that bets on the degree of dispersion among a basket of stocks' performances rather than the basket's collective performance. This structure leverages divergence among the top ten constituents of the S&P 500, offering higher AI upside exposure with lower volatility risk compared to the Nasdaq 100 Index. Strategists recommend purchasing a December-expiry Palladium trade with a 21% strike and a 4% premium. The "Magnificent Seven" Palladium basket has already exhibited significant divergence. Joseph Khouri, Head of Equity Derivatives Structuring for EMEA at Bank of America, noted, "Palladium structures are very active among a broad client base including hedge funds, pensions, and asset managers. Baskets are typically built around investment themes, such as cyclicals versus defensives, beneficiaries versus losers from rate cuts, or AI versus robotics."
UpVar Swaps As the pattern of equities and volatility rising simultaneously becomes more pronounced, trading ideas that bet on this market path are gaining popularity, a pattern observed during both the AI rally and past periods of euphoria. Several banks are promoting so-called "UpVar swaps," strategies that bet on volatility increasing when the underlying asset trades above a certain level. These trades typically profit when the market rallies significantly first, then crashes within a set timeframe. Strategists at Bank of America, JPMorgan, and Barclays all recommend 1-to-2-year UpVar swaps on the S&P 500 or Nasdaq 100. These swaps offer a significant discount compared to plain vanilla swaps because pricing focuses on relatively cheaper call option strikes rather than more expensive put options. UpVar swaps perform best when the market rallies then falls, but remains above the barrier level. Khouri commented, "UpVar swap pricing remains attractive with skew still relatively steep and absolute volatility low. Investors are expressing various views—some are tactical trades on US indices from 6 months to 2 years aiming to capture rising volatility/spot prices; others are using arbitrage structures like selling volatility swaps and buying UpVars."
Upside Opportunities in European Sectors European banks remain a popular allocation, having staged a strong rebound in 2025, with many strategists expecting their outperformance to continue this year. Various trades focus on cheaper upside strategies, for instance, buying a call option on the Euro Stoxx Banks Index with a higher knockout level. The risk with this cheaper option is that it becomes worthless if the index reaches the set level. European mining stocks are also in focus, with strategists suggesting positioning for upside in the Stoxx 600 Basic Resources Index. A recent Barclays report suggested the sector's fundamentals could improve, driven by potential Chinese policy support and AI infrastructure demand, and found spread structures attractive given low volatility and flat call skew. Bank vs. Mining Implied Volatility – 2-month 25-Delta Call Implied Volatility
Hedging Mega-Cap Tech Tail Risk Similar to April of last year, investors are leaning towards buying volatility (Vega) exposure on large tech stocks for protection, betting that volatility will spike during a sell-off. Barclays strategists believe "crash volatility" in the tech sector is a cheap way to hedge concentration risk and AI capital expenditure uncertainty, with structural flows making put option pricing more attractive. They recommend buying December-expiry out-of-the-money put options on Apple and Nvidia. Similarly, Bank of America strategists suggest going long long-dated deep out-of-the-money Nvidia puts with delta hedging, betting that volatility will rise if the stock price falls. Nvidia Implied Volatility
VIX Spread Strategies A major question over the past two years has been whether to hedge macro risks by buying call options on the Cboe Volatility Index (VIX) or by selling put options on the S&P 500. While VIX call options often offer the potential for quick profits during market sell-offs, volatility spikes tend to reverse rapidly. Furthermore, the steep VIX futures curve increases the cost of holding call options, as more expensive forward contracts gradually converge towards the spot index over time. JPMorgan strategists recommend using short-dated call spread strategies to guard against headline risk while utilizing the steep VIX call option skew to limit costs. A team of JPMorgan strategists led by Bram Kaplan noted, "VIX appears disconnected from policy risks, but it could catch up quickly if risks materialize. Systematic investors' positioning is elevated, so if we see market momentum shift and volatility start to rise, deleveraging from these strategies and hedging by convexity products could accelerate the market decline and push volatility even higher."
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