Stocks have risen significantly this year. And investors are now predicting and making big bets that that is going to end next year, with an increase in volatility. (You can read how Bridgewater Associates just made a $1.5 billion bet on the US and Europe stock markets going down between now and March of 2020 in our previous article).
Why is this important?
Traders positioning, the positioning of large hedge funds can tell a lot of what the market is expecting in the near future. That can be a good opportunity to confirm your beliefs about the market, or use the opportunity to go against the sentiment if you believe otherwise. If you do believe otherwise, it is going to cost you cheaper than going with the market if you had to take the options route.
The pessimistic sentiment is evident in an options’ measure called “skew”, which gauges how expensive it is to buy bearish put options versus bullish call options expiring six months from now. The measure is near its highest level of the past five years. That means, investors are much more pessimistic and want more premium for the option to sell than for the option to buy. A half a year from now is somewhere in May, which is after the US democrat’s candidate race is clearer. Much of the uncertainty could be related to the political risk of a strong democratic candidate rising and even winning the elections against Trump. That would be very bearish for the markets and would mean less accommodative policies for large businesses and downward pressure for stock prices.
The recent easing in trade talks, coupled with a better than expected earnings season helped push stocks higher. The Cboe Volatility Index, an options-based measure of market swings, hit the lowest level since April this month. Volatility is currently at very low levels historically.
Source: Wall Street Journal
This is how the volatility looks like within the last year:
As we can see, it really is at very low levels as of late, and no wonder investors are piling onto this trade, expecting some correction in the markets.
How can you take advantage of such a situation? Well, there are Volatility futures, and there are options strategies that can help get exposure to volatility. One of such strategies is called a straddle. This strategy involves buying a put option and a call option, at the same (or a similar) strike price. This can be depicted in the graph below:
As we can see, in the example above, you will pay around $2 for the straddle, however, if the price of the underlying moves by more than those $2 in any direction, you will make money. This is where volatility can really help you capture big returns.