"Volatility is not synonymous of risk but – for those who truly understand it – of wealth." - Francois Rochon
There is a significant catalyst tomorrow with the first Federal Reserve meeting in the cutting cycle. The main discussion is whether it will be a 25 bps or 50 bps cut. Trying to position for such an event seems like madness to us; however, the volatility associated with this event could provide an opportunity to add to existing trades or the trade idea we are introducing in this article. While there might seem to be a lot of uncertainty in markets now, I believe this year is shaping up to finish strong. I expect the $SPX to finish the year at 5,800 or higher.
I don't see much that could significantly derail markets from rallying into the end of the year. Of course, that doesn't mean an unforeseen catalyst won't emerge; that is always a possibility. There have been some immensely healthy developments under the hood of the market despite some carnage in the leading technology darlings:
The equal-weighted SPX rose to an all-time high yesterday.
New net highs in the stock market hit their third highest level of the year.
The Industrials sector just hit all-time highs.
Jobs are still growing, even if slowing.
GDP was recently revised upward, and economic growth and the consumer remain strong.
In other words, if you look under the hood of both the economy and the stock market, there is not much evidence of an impending recession. This means the market is standing on strong footing in many respects, and earnings continue to grow at a pace where equities should work. Right now, we are at a time of a seasonally elevated VIX. Overall, given the strength of the market, the level of the $VIX at around $17 is impressive and reflects the market's strength.
However, seasonal factors suggest there is some weakness ahead. Some weakness could be associated with the Fed's announcement tomorrow. There is currently a two-thirds chance priced in for a 50 bps cut. If markets are disappointed, there could be a mini-tantrum as a result. If the VIX spikes on this news, I suggest you consider loading up on the $VIX puts I am discussing later in this article. If the $VIX collapses, consider loading up on the October 16th, $16 call options that I have already mentioned in a prior iteration of Black Swan Party.
Given the fundamental strength of the market, I don't find it unreasonable that the volatility index will spend much of December in the $12 and $13 range, as it did last December. Thus, I think now is a good opportunity to use the volatility associated with the Fed announcement to add to a $VIX short. I would be perfectly comfortable buying this contract today before the Fed announcement as well, but I think it is very important that if the VIX spikes at all on the Fed announcement, you buy more if the price goes down.
So, to me, the right contract to play a subdued VIX during the holiday season would be the following:
Buy the December 18th $15 VIX puts and hold them to expiration. These are currently trading at $0.87.
If there is an adverse reaction to the Fed meeting tomorrow that causes the $VIX to spike, then please add more to this position and lower your cost basis.
If, on the other hand, volatility collapses in the wake of the Fed meeting, then add to the October 16th $16 call options we have already discussed. These are currently trading at $3.00 and are up 20% from where we originally discussed them.
This trade and the suggested subsequent action, which depends on how the market responds to the FOMC meeting, is meant to play the typical seasonality of the volatility index. Right now, we are focused on a cornucopia of scary risks, but it's important to remember that most risks we focus on rarely result in adverse price action or significantly elevated volatility. Seasonality is important to focus on at a market-wide level, and the volatility index is market-wide implied volatility.
As you can see, we've had quite an anomalous year as far as volatility goes. I've been of the opinion since the large spike on August 5th that we would be in for some mean reversion to lower volatility levels. I think this will play out into the end of the year and will make the outcome for the contracts discussed today very fortuitous. We could still be in for a seasonal spike in volatility later in the month or in early October, but that's why I've also suggested you hold the $16 call options that expire on October 16th. These are primely positioned to expire when there's a high chance of a seasonal spike.
