The stock and options markets are singing different tunes.
Index trading patterns in the options market indicate it isn’t ready to concede that the worst is over for stocks, even though the Cboe Volatility Index, or VIX, has fallen from bearish levels to a range that suggests enthusiasm for equities.
The stock market, meanwhile, is behaving with extraordinary vigor, retracing recent losses triggered by fears that the Omicron coronavirus variant has more antibody-resisting mutations.
Which market is right?
The situation is as fluid as the stock market’s erratic behavior, and it’s too early to reach a hard conclusion.
Still, the increased interest in buying put options to hedge stock portfolios indicates that sophisticated stock investors—and that’s who trades puts and calls—are increasingly risk averse.
Rather than committing to the bullish or bearish side of the market, investors could simply do nothing until the Federal Reserve concludes its two-day meeting on Dec. 15, when it might confirm expected changes to monetary policy and thus provide a more stable backdrop for equities.
Some contend that the Fed has already telegraphed what will happen via the testimony of officials. Maybe that sanguine view will be validated, but the recent sharp swings in stocks and the VIX suggest that investors are more on edge than acknowledged.
Those who feel compelled to act ahead of the Fed meeting could consider a strategy that positions them to buy quality stocks at lower prices and to participate in gains.
The edginess among investors evident in the options market generally means that put prices are often plump with fear premiums, while the historic greed premiums have ebbed lower in many bullish calls. Selling a bearish put and buying a bullish call enables long-term investors to attach themselves to the stock market’s primary pistons.
Consider the Financial Select Sector SPDR exchange-traded fund (ticker: XLF). The financial-sector proxy should benefit from rising interest rates and a healthy economy. Even though the ETF is dancing around a 52-week high, the future might be even brighter if the central bank increases rates.
With the ETF at $39.08, investors could sell the January $35 put and buy the January $42 call. The risk-reversal strategy, which yields a credit of 10 cents, positions investors to buy the ETF at $35 and to profit from gains above $42.
During the past 52 weeks, the ETF has ranged from $28.11 to $40.86. It is up 33% so far this year, outperforming the 25% return for the S&P 500 index.
The risk to the strategy is if the ETF plummets. If it fell to $25, for example, investors would be obligated to buy shares at $35 or to adjust the position in the options market to avoid assignment. Should it be at $45 at expiration, the call is worth $3.
The Fed’s devotion to extraordinarily low interest rates has been a key reason behind the stock market’s rally to record highs. When the cost of capital is low—as it has been, thanks to the Fed’s use of easy-money policies to stimulate the economy since the 2007-09 financial crisis—investors could scoot ever outward on the so-called risk curve and buy stocks and calls to profit.
If the Fed changes course, that could ultimately jeopardize economic growth. If the economy suffers and inflationary pressures become more pronounced, the Financial Select Sector SPDR ETF could be in the eye of an economic storm—so consider this strategy only if you can warehouse the position for three to five years.
Steven M. Sears is the president and chief operating officer of Options Solutions, a specialized asset-management firm. Neither he nor the firm has a position in the options or underlying securities mentioned in this column.