Market Volatility Spells Opportunity for Options-Savvy Investors

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Once again, the stock market is confronting a dramatic shift.

The illusion that inflation was peaking, and that the Federal Reserve wouldn’t raise interest rates so aggressively, was recently demolished—and this means stock valuations are aggressively open to bearish interpretations.

Jerome Powell, the central bank’s chairman, bluntly said at the Fed’s summer retreat in Jackson Hole, Wyo., that ridding the economy of inflation will be painful. Ever since, the stock market has behaved like a dog afraid of its master. Its fear gauge, the

Cboe Volatility Index,
or VIX, has advanced in anticipation of another beating.

The powerful rally that began in mid-June now seems to have been revealed as the mother of all bull traps. Investors who bought stocks in anticipation that the Fed would become a benign presence have been proven wrong. Anyone who hedged positions in early August is likely pleased. Doing so now is often outrageously expensive.

It’s hard to know what happens next, ahead of the Sept. 21 conclusion of the Fed’s rate-setting committee meeting. Investors are debating if rates will rise a half-point or three-quarters of a point. The bank will also release a summary of economic projections, which will offer insight into the Fed governors’ views on the future of economic growth, unemployment, and inflation.

There is an undeniable downtrend in the equities market, and rising rates might soon make bonds an attractive alternative to equities, which is a fact not fully appreciated. Many investors have never known a time when there was an alternative to stocks.

Still, stock necromancers have loads of data suggesting all sorts of bullish opportunities exist. Maybe they’re right, even if they rarely mention hard-to-understand risks like the Fed’s plans to reduce its balance sheet and how that could hit the markets like Mike Tyson’s right hook.

Most people are likely better off letting the market reveal itself. Options-savvy investors are different. They know an elevated VIX can create opportunities.

When the VIX is high, it’s time to buy. Should the VIX, now around 25, hit 30 or higher, it will indicate that investors have begun to panic. Already, some are buying expensive put options to hedge their stocks. That’s an opportunity for well-capitalized, long-term investors who can manage options positions.

When others are insensitive to the price of buying defensive puts—a sign of real fear—long-term investors can help dealers satisfy that demand. Unlike dealers, however, individuals can pick their spots.

Identify stocks you own and want to own more of, and stocks worth buying. Consider selling cash-secured puts that expire in about a month to buy the stocks at 10% or so below the market price.

Consider

American Express

(ticker: AXP). The stock offers a way to monetize the view that the wealthy won’t be terribly affected by an economic downturn. They will keep spending and traveling.

With the stock at $152.25, AmEx’s October $135 put could be sold for about $2.15. During the past 52 weeks, the stock has ranged from $134.12 to $199.55. If the stock is above the strike price at expiration, investors keep the put premium. Should the stock be below the strike price at expiration, investors can buy it at an effective price of $132.85 (strike minus premium), or adjust the put to avoid assignment.

This style of trading is suitable only for investors who can warehouse positions for three to five years. The time span should provide enough opportunities for the world’s many woes to work themselves out. If not, we will all have far deeper problems than losing money on blue-chip stocks.

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.

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