Investors Are Frightened. How to Use Their Fears to Profit.

Fear is back in fashion.

It’s hard to be definitive about anything in such an erratic environment, but the latest Covid variant, coupled with the realization that the Federal Reserve’s easy-money policies may end sooner than expected, has roughed up stocks and elevated fear premiums in the options market.

The market’s fear gauge—the Cboe Volatility Index, or VIX—had seemed stuck at a somnolent level, as if to suggest investors had forgotten stock prices sometimes decline. It has surged in recent weeks.

The VIX was around 15 in late October and recently peaked around 32. Some strategists contend that a level of 30 in the VIX signals fears of an economic recession.

In testimony Tuesday before the Senate Banking Committee, Fed Chairman Jerome Powell said it was time for the bank to stop characterizing inflation as a transitory phenomenon. The stock market sank in response and the VIX surged, though it has since reversed some of the move.

Much will be made of the VIX’s peregrinations, but this much we know: Investors who have long shunned put options are now buying them to hedge their portfolios. The trend began in August, even as stock prices kept marching higher. Yet it took the emergence of the Omicron variant—and Powell’s seeming recognition that inflation might not fade so quickly—to firmly change investor sentiment.

The sudden demand for puts, which increase in value as stock prices decline, has helped to recast an odd market dynamic that has characterized much of the year.

As stock prices advanced ever higher, call option premiums tended to rise, too. The rush to buy calls, which increase in value as stock prices rise, has made bullish calls often more expensive than bearish puts.

The opposite is usually the case.

The shift back to normal market dynamics is, at least for now, an opportunity for anyone who uses options to navigate the stock market. For investors who want to buy stocks on weakness, elevated put premiums might look attractive. By selling a cash-secured put, investors can get paid by the options market for agreeing to buy a stock at a lower price.

The put-sale approach works best for investors who have high convictions about a stock and a horizon long enough to overcome short-term volatility.

We have consistently advised investors to consider selling puts on blue-chip stocks that pay a dividend and that can be held for three to five years. Now, however, it makes sense to be more nuanced. It is hard to have any clarity around the Omicron variant or even the Fed’s actions.

Aggressive investors looking for an opportunity to trade should consider sticking with options that expire before the Fed concludes its next meeting on Dec. 15. It’s hard to know how the market will react to more hawkish commentary about rates and tapering, or even the absence of such comments.

For those who can’t wait, and for those who always like to trade, consider selling puts that expire Dec. 10. One possible vehicle: the Technology Select Sector SPDR exchange-traded fund (ticker: XLK), which comprises many major technology companies that could be viewed as safe havens in uncertain times.

With the ETF at $166.41, aggressive investors could sell the December $161 put that expires Dec. 10 for about $1.50.

After the Fed concludes its meeting, and the fog somewhat clears from the market, the position could be reset in reflection of the market’s changing dynamics, which are surreal enough to have inspired Salvador Dalí.

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Originally Posted on December 2, 2021 – Investors Are Frightened. How to Use Their Fears to Profit.

Updated December 3, 2021 / Original December 2, 2021

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.