In today's complex financial world, it seems like everyone is talking as if they're expert fund managers, discussing stocks, interest rates, monetary policy, geopolitics, and all the nuanced factors that affect price discovery.
But amidst all this complexity, there is a relatively simple way to act like a global fund manager who is equally comfortable in any asset class. And it's right in front of us, hidden in plain view.
Recently, the implied volatility of the S&P 500 index has reached a three-year low, even as the benchmark index edges closer to its all-time high. This presents an opportunity for investors to embrace one of the fundamental principles of successful investing: buying low and selling high.
Traditionally, this principle is applied by purchasing stocks at low prices and selling them when prices are high. However, there is a more sophisticated approach that takes advantage of pricing differentials: selling stocks and buying options when implied volatility levels are low. As we have observed in recent weeks, options volatility is currently nearing historic lows while stock prices continue to climb.
According to Goldman Sachs, the implied volatility of individual S&P 500 stocks over one month, which is essentially equivalent to buying shares in the options market, has recently hit a three-year low of 20. This means that options are trading without the fear or greed premium, even as many investors grapple with both emotions.
Furthermore, the Cboe Volatility Index (VIX), commonly referred to as the fear gauge, recently touched its lowest point of the year at 12.45. This indicates that overall market volatility is hovering around levels not seen in decades.
The key takeaway from all this is that there exists a unique opportunity for investors to capitalize on the current market dynamics. By recognizing and understanding the significance of low implied volatility, investors can make informed decisions about buying and selling stocks and options.
So instead of getting caught up in the complexities of the financial world, let's focus on this straightforward yet powerful strategy: buying low, selling high, and taking advantage of low implied volatility.
The Mechanics Behind Options Volatility
In the midst of global uncertainty, including war, rising interest rates, and economic pressures, one might find it surprising that options volatility is actually declining. This phenomenon can be attributed to the mechanical nature of markets.
When stocks are on the rise, options pricing computers tend to assume that the future will mirror the past. As a result, options volatility often decreases during periods of stock growth. Some investors take advantage of this trend by purchasing bearish put options as a way to hedge their stocks, while others opt for bullish call options in anticipation of gains.
Let's take a closer look at Amazon.com, a stock that has performed exceptionally well this year with a 75% increase. If Amazon dominates the holiday shopping season, it is reasonable to expect that the stock will reach a new all-time high price, surpassing its previous record of $186.57 set in July 2021. Over the past 52 weeks, Amazon shares have fluctuated between $81.43 and $149.26.
This enticing prospect leads intrigued investors to two main strategies. Those who already own Amazon stock can consider selling their shares and replacing them with January call options. On the other hand, those who don't currently own shares but have an interest in doing so can purchase calls as a substitute for actually owning the stock.
If Amazon's stock is currently valued at around $147, investors could acquire the January $150 call for approximately $4.35. If Amazon experiences a surge, reaching $170, the value of the call option would be $20. However, if the stock fails to meet the strike price at expiration, the trade will not be successful. It is important to note that both selling stock and realizing profits from options can result in tax obligations, so investors should carefully consider this aspect before making any trades.
In summary, while current global conditions may suggest heightened risks, the decline in options volatility is a testament to the mechanistic nature of markets. By understanding this dynamic, investors can capitalize on opportunities while navigating potential pitfalls along the way.