How to Play the Market When Threats Abound

The stock and options markets are eerily calm as world leaders try to avert a ground war in the Middle East. It is unclear if those efforts will persuade Israel to not level Gaza after Hamas terrorists murdered many Israelis. Iran is threatening to attack Israel, too. The outcome is impossible to anticipate, and investors are advised to proceed carefully amid such uncertainty. Here are a few ideas to ponder as the world smolders.

What happens between 4200 and 4400 in the S&P 500 index is a pantomime play in reaction to uncertainty. The market’s true trend should be revealed beyond those support and resistance levels. Until then, rallies are likely reactions to oversold conditions, and declines are signs that investors—humans and computers—are struggling to make sense of what may happen in the wake of Hamas’ attack.

It is easier to trade trends than market turns. Trading Nvidia (ticker: NVDA), for instance, to monetize the artificial-intelligence trend is simple. Monetizing complicated macro events is almost as difficult as Middle Eastern diplomacy. Be humble.

The volatility that increasingly characterizes the stock market’s daily moves is concerning. The sharp swings suggest investors are struggling to solve the stock market’s jigsaw puzzle amid rising geopolitical risks. Most investors should hesitate to draw hard conclusions about what happens next—in the markets or the Middle East—until more facts are revealed. Remember, war is a continuation of politics by other means, as Carl von Clausewitz put it.

One-day movements of anything, such as big stock advances and sharp drops in the Cboe Volatility Index, or VIX, are meaningless. Isolated big up moves should be viewed as “socially acceptable volatility” until major risk factors are removed from the analytical equation. No one complains much about surging stocks or a falling VIX, but unusually strong moves, even if bullish, can be out of character for the market and should be viewed with the same concern as bearish moves.

The VIX has been meaningfully higher this past month—but at around 18, it isn’t high enough to send a powerful trading signal. The VIX’s long-term average is around 19. At 25 to 30, it is high enough to broadly consider the resumption of incremental put and call option-selling strategies. At 35 to 40, it is telegraphing that it is a great time to engage in time arbitrage—that is, selling short-term options with high volatility and buying blue-chip stocks that can be warehoused for three to five years. The great risk isn’t what the Federal Reserve does next but whether war erupts in the Middle East, Asia, or Europe.

Fear and erratic price movements are the friends of long-term investors. When investors panic, investors often can buy the stocks of great companies at incredible prices. Options-centric investors can benefit from selling cash-secured puts to scared stock investors who want to hedge.

If the VIX is too abstract for you, look inward. If the stock market scares you, or you feel like you might vomit in reaction to the day’s events, or you don’t want to look at your stock portfolio, it’s probably a good time to buy stocks. Investors are often too bearish and too bullish.

Corporate earnings season may not clarify unusually cloudy conditions in the financial markets: bonds, commodities, stocks, and options. The operative fact of this earnings season is that it is immaterial if a company beats earnings by a penny, ups the stock buyback and dividend, and offers a constructive outlook if something happens to interfere with the ability of capital to flow across borders and for people to spend money.

Traders react, and investors consider, as Steve Sosnick, Interactive Brokers chief strategist, likes to say. “Don’t react to every piece of news,” he tells Barron’s. “Be thoughtful and watch your risk.”

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Originally Posted October 18, 2023 – How to Play the Market When Threats Abound