Volatility Is Good. How to Use It.

If interest rates aren’t going to increase, does it matter when the Federal Reserve cuts rates?

The question must be posed in light of the market mob’s temper tantrum after Fed Chairman Jerome Powell said in a 60 Minutes interview Sunday night that rate cuts might happen later than expected.

We noted as much in early January, but the market mob hears what it wants to hear when it wants to hear it.

Yet it ignored the most obvious fact: The stock market, and economy, are doing just fine with the 10-year Treasury note yield above 4%.

Earnings season is under way, too. Reports are good for many companies, and excellent for some. Many investors seem surprised that corporate profit margins are quite robust—and that companies have teams of executives who are focused on improving profitability.

Recent economic data has been better than expected. The economy miraculously seems to have adjusted to the pressures of higher rates like a weightlifter whose training regimen makes him stronger.

Those are the facts. Clearly, price volatility is good for stocks, especially when indexes are near record highs.

When stocks decline in an orderly, nonpanicked fashion, as occurred earlier this week, it’s actually healthy for the stock and options markets. Traders refer to such conditions as a “two-way flow,” as it brings together natural buyers and sellers.

The price weakness clarifies investor sentiment, and that often increases options volatility. Why? Investors tend to buy bearish put options when something challenges their bullish views, and that increases implied volatility.

The latest stock kerfuffle should therefore be viewed as a reminder of the merits of an options strategy that we have long called “time arbitrage.”

When stock prices weaken, long-term stock investors can take advantage of short-term fear by selling cash-secured puts on favored stocks—a strategy that requires investors to have the money to buy shares at the strike price. This enables long-term investors to monetize the fear of other investors. Scared investors often rush to buy puts, usually paying too much to hedge. They become insensitive to price, and that is what makes the time arbitrage strategy so enticing.

Investors should thus have a list of stocks they want to own, or want to buy more of. They also should take note of investment themes that represent key trends shaping the world around them, like artificial intelligence, the aging of America, the rise of private financial markets, and healthcare innovations.

When the market mob panics, time arbitragers can enter orders to sell cash-secured puts to fellow investors who will pay just about any price you ask.

Most of the time, the burst of fear is over in a day or so, and the stock price bounces higher and settles above the put strike price. This means that anyone who sold puts gets to keep the money they received for selling the contract. The worst case is that the stock falls below the put strike price, and the put seller gets paid by the options market to buy a stock they wanted to own anyway.

Consider Equinix. The data-center operator is a play on rising demand from corporations that need places to store all their servers and related equipment.

With the stock around $838, investors could sell a cash-secured March $760 put. Should the stock be above the strike price at expiration, investors keep the put premium. If the opposite happens, investors must buy the stock or roll the position to avoid having to do so.

Time arbitrage has some other important qualities. It creates order in moments when little exists, and it keeps investors aligned with the merits of buying quality stocks when they are mispriced.

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Originally Posted February 7, 2024 – Volatility Is Good. How to Use It.