The financial world has become so complicated that many folks increasingly talk like they are sophisticated managers of multi-asset-class funds.
They often orate about stocks, the trajectory of interest rates, monetary policy, geopolitics, and all of the complications that contribute to that mystical process known as price discovery.
It’s a tall order to act like a global fund manager who is as comfortable in one asset class as another. But a relatively simple opportunity to do just that is hidden in plain view.
The implied volatility of the
S&P 500 index
has recently fallen to about a three-year low, even as the benchmark index seems intent on retesting its all-time high levels. That gives investors the opportunity to embrace one of the fundamental tenets of successful investing: buying low and selling high.
In theory, investors follow that rule by buying stocks when prices are low and selling those stocks when prices are high. (In practice, many do just the opposite, but that is a topic for a different time. Besides, we need useful idiots to make this difficult pursuit just a little easier.)
A more sophisticated way to take advantage of pricing differentials is selling stock and buying options when implied volatility—the most important factor behind options prices—has fallen to low levels. And as we have noted in recent weeks, options volatility is approaching historic lows, and as it keeps declining, stocks keep rising.
According to Goldman Sachs, the implied volatility of any given S&P 500 stock over one month—essentially the options market equivalent of buying shares—recently set a three-year low of 20. In translation, this means that the options are trading without a fear or greed premium, even as so many investors are suffering from both maladies.
The
Cboe Volatility Index,
or VIX, also recently set a low for the year, touching 12.45. The so-called fear gauge is hovering around its lowest levels in decades.
All of this might seem like an incredible statement on the world at a time when risks seem unusually high due to war, higher interest rates around the world, and economic pressures here and abroad. But the decline in options volatility, in the simplest expression, reflects the mechanical quality of markets.
When stocks rise, options pricing computers tend to assume that the future will be like the past. This means that options volatility often declines as stocks rise. Some investors use the phenomenon to buy bearish put options to hedge stocks, just as others buy bullish call options to wager on gains.
Consider
Amazon.
com, one of the year’s top-performing stocks. Shares are up 75% this year. If Amazon dominates holiday shopping, it is reasonable to bet that the stock will set a new all-time high price, taking out its July 2021 record of $186.57. During the past 52 weeks, Amazon shares have ranged from $81.43 to $149.26.
Intrigued investors have two main choices if they want to wager that the holidays will make Jeff Bezos even wealthier than he already is. Investors who own Amazon stock can sell their stock and replace it with January call options. Those who don’t own shares, but want to, can buy calls as a stock substitute.
With Amazon stock around $147, investors could buy the January $150 call for about $4.35. If Amazon surges to $170, the call is worth $20. If the stock is below the strike price at expiration, the trade fails. Of course, both selling stock and realizing profits on options generates tax bills, so investors should be mindful of that before trading.
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