On January 11, 2018, I wrote about volatility. You had almost a month to ponder my advice before the market tanked.
Here’s an excerpt from the article…
Today [January 11, 2018], the VIX is at 9.7. This means that investors are betting the market will be either 10% higher or 10% lower in the next 12 months. Typically, this would indicate that investors should be selling. But since it’s different this time, investors are buying more and more.
TD Ameritrade reported that the retail investor (you and me) has more exposure to the stock market than ever. Charles Schwab reported that customer cash balances reached their lowest levels on record. In other words, the crowd is all in.
At 9.7, the VIX is 50% below the norm. That is a huge statistic and should not be ignored. Put another way, the downside to the VIX is limited from here, while the upside is massive…
Then I said this…
The twist is that the VIX can stay low for years as complacency, by definition, is not a quick function. So you may have a few weeks, months, or even a year or two when the market will do its best to lure you in. I can’t predict when that turn will occur. I can predict that it will occur, however, and that the carnage that will follow will be ugly, just as it always is.
The question you must ask in the face of all the mounting evidence that we are at very high valuations in the market is this: Do YOU believe it’s different this time?
I don’t. And I am certainly trimming my exposure to the market or using strategies that hedge my bets or allow me to buy select companies at much lower prices than where they are trading today.
I recommend you consider doing the same.
The correction isn’t over, not by a long shot. The market may recover all of its losses, but volatility is back in the spotlight. And while that may be bad news for investors in the short term – prices will fluctuate all over the place – it’s a trader’s dream. For options traders, it could not get any better than this.
In fact, this may be the best time in five years to be an options trader, especially if you’re selling options.
The Black-Scholes options pricing model has several components that make up the price of an option.
The main components are…
- Days to expiration
- Underlying share price
- Strike price of the option
- Volatility of the underlying share price
- Volatility of the market
- Risk-free rate of return (usually the yield of the 10-year Treasury bond).
Usually, when one of the components moves, the price of the option reacts to that move.
This time, three of the components are moving in tandem. When market volatility, share price volatility and the risk-free rate of return are all moving up, the prices for options move like a scalded cat.
Interest rates are looking like they’re going to be moving higher from here. Inflation is back. And tax cuts during a booming economy are akin to throwing “lighter fluid on a fire,” as the CEO of Goldman Sachs recently put it.
Get ready for a wild ride in 2018. Make sure you are always protected by using trailing stops and, yes, by using options to reduce your total exposure to the market.