Today, the S&P 500 and the Dow hit their all-time highs. Considering the uncertainty over trade, geopolitics and global economies, that might sound strange. But it does make sense.
The Fed didn’t lower interest rates this week. But no one, well few, expected such an action just yet. Instead, the group cut the word “patient” from its language regarding future policy actions. This is signaling the FOMC is likely to cut rates soon… at least according to Wall Street.
A rate cut makes equities even more attractive. With the fixed-income world staring at tiny and soon-to-be falling rates and cash at risk of inflation following a rate cut, that leaves stocks. So, all-time highs do somewhat make sense.
But there’s a lot more to this story. All-time high stocks generally mean lower volatility. But the best measure we have to judge market volatility is the CBOE Volatility Index (VIX). And it is up on the day… by a whole point or 7%.
Higher stock prices coupled with higher volatility isn’t incredibly rare. But it isn’t common either. Normally, when the market rises, that’s a signal that investors are more comfortable investing. That makes sense. But sometimes, stocks go up even though the uncertainty remains.
You’d have to go back to the summer of 2009 to find many days like today’s, when the market rallied alongside volatility.
The reason for this is that the recent crash was still in everyone’s minds. We had a new president. The auto industry was just going through bankruptcy. New regulations and bailouts were still working their way through the system. So, despite a clear bottom forming, investors were nervous there might be a second dip… probably the most common phrase in financial media at the time.
Today, it’s very different yet sort of the same.
We have had a 10-year steady recovery, better than most could have ever hoped back then. Despite giant challenges, like several government shutdowns, continued foreign wars, and a massive leadership change in Washington, this recovery has continued.
However, investors are fearing many new elements that weren’t there for the majority of the recovery. China’s economy is on the skids, in large part due to a new trade war that is engulfing the global economy. We’ve had threats of war with Iran over the last decade. But now we have attacks on tanker ships and shot down drones.
Just as worrisome to many investors, we have an upcoming trade negotiation at the end of this month that could make or break this fragile market top. And that’s where today’s trade opportunity comes in.
No doubt, some of today’s rise in volatility comes from fears and hopes that the U.S. and China will come to terms about the ongoing tariffs when Presidents Trump and Xi meet in Japan later this month. And if you look around, many are suggesting this is already priced into the market. But it simply cannot be.
You see, it’s impossible to know what will come of this meeting. The two leaders seem to get alone on an individual level. But that hasn’t stopped either from diving into larger and larger tariffs on more and more trade goods.
What’s more, this isn’t the only meeting that will involve trade with a billion-plus population country Trump will have at the G20. He is also sitting down with newly reelected Indian Prime Minister Narendra Modi – who just this past weekend introduced his first wave of tariffs on U.S. goods.
The point is that we may see higher stock prices – hopefully we do – but we should almost certainly see higher volatility. If you look at the past few months of the VIX, you’ll see that this renewed wave of volatility isn’t actually yet priced into the market:
As you can see, just a month ago, the VIX was much higher than it is today. With the trade negotiations – and all the corresponding speculation that will come out of those – and the fears of yet another Middle East conflict, the VIX should rise again in the short term.
While you can’t directly invest in the VIX itself, there is a way to play it. The iPath Series B S&P 500 VIX Short-Term Futures ETF (VXX) tracks the movement of the VIX near perfectly. So, when you want to trade the VIX, this is the best way.
As you can see, just three weeks ago, the VXX was trading at $30. That was after a rough month of heavy losses in the market. Since the June rally began, volatility has declined – as noted above is the most common reaction by the market. But with so much riding on the G20 meetings and international fears, it’s ready for another bounce.
Fortunately, there’s a perfect way to play it.
A Strategy to Trade Higher Volatility
A bull call spread is a type of options trade that involves buying one call option with a strike price near the current trading price of the underlying stock or ETF and selling a second call option with a higher strike.
This results in a long trade that becomes more profitable as the underlying equity rises in value. But because of the second call, both the maximum potential profit and the cost (and therefore the risk) of the trade is capped.
You can see what that looks like here:
Source: The Options Industry Council
Considering the volatility of the overall market is bound to jump over the next month, the expirations for a trade on this action should be set for mid-July. This will predate the next FOMC meeting. But since this is a play on volatility – which is a forward-looking characteristic – most of the runup to that meeting will still play into this trade’s hands.
Let’s look at a specific trade to get a sense of how much money it stands to make if volatility does rise.
A Specific Trade on Volatility
Right now, a trader can buy a July 19 $26 VXX call for $1.89 per share and sell a July 19 $30 VXX call for $0.82 per share for a total cost of $1.07 per share. Since each represent 100 shares of VXX, that’s a net debit of $107.
That’s the most this trader would have at risk. So, if everything goes perfectly smooth and investors stop worrying about the outcome of trade negotiations, possibilities of war with Iran and interest rate cuts over the next month, the most at risk is $107.
But if that sounds crazy… if investors continue to fret and worry about those things… the return is far greater.
To find that, take the difference in strike prices ($30 – $26 = $4), and subtract the cost ($4 – $1.07 = $2.93). Based on 100 shares, that’s a maximum potential profit of $293… or 274% return on the amount at risk.
That would take a large jump, of course. But as you can see, short moves up to $30 in the VXX are frequent. This trade is straightforward: if investor remain worried throughout the next month of wild news cycles, the trader has a chance to more than triple his money.