How to Play a Market That Shrugs Off Everything

The stock and options markets are suffering from what might be called Neropathy. Just as the Roman emperor Nero played his fiddle as Rome burned around his palace, the markets are seemingly oblivious to the pain and destruction that has enveloped much of the U.S. and the world.

Despite massive unemployment and severe economic contractions sparked by an as-yet incurable virus, the Dow Jones Industrial Average and the S&P 500 index are nearing their highest levels ever. Not even days of nationwide protests sparked by the death of George Floyd while he was being arrested in Minneapolis have tarnished the stock market’s momentum.

Tens of thousands of people are demonstrating in the streets, venting their anger about police brutality and social inequities that never seem to go away. President Donald Trump is bellicose. He berated governors for being “weak,” while his defense secretary told them to “dominate the battlespace” in their cities.

Earlier in the week, the Congressional Budget Office warned that it could take more than a decade for the economy to recover from the coronavirus pandemic. Yet the stock market marches ever higher. A key measure of the risk of owning stocks, the Cboe Volatility Index, or VIX, is purring like an innocent kitten that is lapping up dour economic reports like sweet milk.

Some credit the Federal Reserve for rescuing stocks for the second time in a decade with low rates and easy-money policies, but others fret that the mighty “Fed put” could ultimately be overcome by the added risks of the latest events.

Michael Schwartz, Oppenheimer & Co.’s chief options strategist, told Barron’s that he is increasingly struck by the singularity of this moment in market history.

“I have lived through many unique events over the past five decades on Wall Street,” he says, “but this market seems to defy all logic based on historical experiences and data.”

Stock prices are driven by corporate earnings, and earnings are influenced by economic conditions here and abroad. The equity market doesn’t seemingly reflect reality.

Since the S&P 500 bottomed on March 23, it has gained more than 37%, while many stocks and sector funds have experienced more dramatic advances.

Chris Jacobson, a Susquehanna Financial Group strategist, told clients that investors appear eager to look past headwinds including deteriorating relations between the world’s two largest economies, U.S. and China, that should suppress investor enthusiasm to buy equities.

“The market is done with ‘Buy the dip and sell the rip.’ It’s now ‘Buy the dip and buy the rip,’ ” Dennis Dick, a Bright Trading proprietary trader, tweeted on Wednesday.

Many investors are caught in the middle. They aren’t willing to sell and miss this extraordinary rally, but don’t want to put new money in stocks at these high levels. We know that people are curious about how to participate in the stock market without taking on incredible risk. A solution: selling put or call options on the S&P 500.

Calls give a buyer the right to buy stocks at a certain price and time; selling them is a bet on the market’s expected trading range. Puts give a buyer the right to sell stocks at a certain time and price; selling them expresses a view that prices will rally higher.

If the sellers are right, they collect a wad of cash, and if they are wrong, they roll the trade to another month and try again. Tax treatment is favorable—60% of gains are taxed at long-term rates, while 40% are taxed as short-term gains.

The traditional S&P 500 trade is selling puts or calls that are 100 points above or below the index’s level, but some investors are updating the strategy to reflect the current market. They are using strike prices that are 200 points away from the market, reflecting the extraordinary price swings that now define this Neropathic market.

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Originally Posted on June 4, 2020 – How to Play a Market That Shrugs Off Everything