Get ready for a volatile fall season.
Even though options volatility seems to be permanently depressed due to the popularity of options-selling strategies that keep a damper on options prices, investors are well advised to prepare for a dramatic autumn.
So many economic and political forces are swirling about the market that the risk is high that investors soon begin to worry about stock valuations. Now is a good time to prepare for a burst of volatility because few investors are prepared for it.
A broad measure of options implied volatility, the Cboe Volatility Index, or VIX, is around 15, below its long-term average of 19. The fear gauge's subdued level reinforces the notion that robust corporate earnings can insulate markets from most anything. But that thesis, and VIX's low level, could soon be tested by the seasonally volatile months of September and October, bellicose political leaders, and controversial economic policies.
To wit, U.S. Treasury Secretary Scott Bessent, who increasingly acts like the cunning hedge fund trader he once was, is acting like the de facto head of the Federal Reserve. He is using Treasury's vast resources to try to lower long-dated bond yields, and to economically isolate Iran.
Kevin Warsh, the new Fed chairman, meanwhile, has told investors to focus on market forces rather than on pronouncements made by central bankers. But Warsh is about to make a highly anticipated speech at the Jackson Hole Economic Policy Symposium that investors hope will better explain his views.
Not to be outdone, President Donald Trump has threatened increased tariffs on Canada and claims that the Strait of Hormuz belongs to America as he seeks to topple the Iranian regime.
Meanwhile, the U.S. national debt just hit $40 trillion, inflation seems too elevated to support the interest-rate cut so desired by Wall Street, and the Nov. 3 midterm elections could challenge Trump's control of Congress.
Those chaotic forces-coupled with perennial concerns that artificial intelligence is creating a speculative bubble or optimism about a golden age for humanity-favor positions that benefit from increased options and stock price volatility.
We just recommended the State Street Financial Select Sector SPDR to broadly benefit from volatility, and now it seems prudent to establish stock-specific positions.
To our late-July recommendation to trade Goldman Sachs, we add Charles Schwab, the online brokerage behemoth, on the theory that it benefits from increased price volatility because that increases trading volumes.
With the stock at $113.05, investors can sell the October $110 put for about $2.65 and buy the October $120 call for about $1.80.
The risk-reversal strategy-selling a put and buying a call with a higher strike price but same expiration-pays investors to buy Schwab's stock at an effective price of $107.35, and positions investors to profit above $120.
By selling the put, investors monetize the fear of other investors who are concerned the stock might decline after recently setting a new 52-week high price.
If our analysis is correct, and the stock advances, the call will increase in value. At $125, the call is worth $5.
Equity proxies for volatility, like Schwab, are well positioned to thrive in these charged times. Even though there is a rising risk that politicians may spook investors and spark a big risk-off event that pummels the S&P 500 index, stocks that benefit from trading activity tend to do well when others are under pressure.
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