The equity market rallied nearly 10% in January alone, and this is despite Fed Chair, Powell, not easing up on his hawkish stance on interest rates.
And at the same time the market has rallied with some momentum, the yield curve has inverted.
The Federal Reserve Bank of Boston has indicated that the measure of the yield curve has been shown to have “robust predictive” power for future recessions.
It looks like the equity markets are at odds with the bond market, and only in the future will we see who wins this battle, but as the Fed’s inclination to raise interest rates even higher than forecasted, we just may have a hint.
And as equity markets have softened a bit in the past couple of weeks, you can count on a break from neutrality either up or down soon.
So, as the equity/bond markets tug-o-war will wraps up, I want to show you how you how to profit with a combination option strategy as stock prices either rise or fall sharply.
What the Equity/Bond Tug-O-War Is Leading up to
Under ordinary circumstances long-term bond investors will receive higher returns because they’re willing to invest their money for longer durations of time, and that comes with added risk. It’s simply easier to “predict” what might happen in the short run than it is the long run.
The image below illustrates what has happened to the yield curve.
On the left you’ll see the yield is lower for short-term maturities, and then yields increase for longer-term maturities.
It’s rising concern in the near future that causes an inversion. If you look at the right side of the image you can see that short-term interest rates have outpaced long-term – creating an inverted curve.
With few exceptions, history has shown us when economic concerns are high enough to cause a yield inversion, recessions follow. The equity market usually leads recessions with a decline, followed by rising unemployment as recessions deepen.
So, as Federal Reserve Bank of Richmond President said, the central bank may need to raise interest rates higher than previously anticipated, which could be the catalyst for the bond market to push the equity market overboard.
But let’s talk about a strategy that can profit when the tipping point occurs.
Implied Volatility (IV) Rises with Heightened Economic Uncertainty
So far this year the Volatility Index (VIX) has been sticking close to the low end of its range, which simply means that option premiums are more fairly valued – cheap, one might even say.
So, buying calls and puts in a low VIX environment creates an advantage for us.
That brings me to the options strategy that I employ when IV is lower with the potential to increase – the Straddle.
First let me tell you what the strategy consists of. It’s quite straight forward…
An options Straddle is the combination of a long call option and a long put option, sharing the same strike price and same expiration. It’s that simple.
My Vega Burst subscribers use the Straddle trading strategy regularly throughout earnings season, and this strategy can be used in other events as well. The benefit of the trade comes with rising IV. And, there is one big reason implied volatility will increase… uncertainty.
You might find investors becoming more uncertain when a company is about to report earnings, or when an FDA approval announcement is approaching; and, you may benefit from the impact of uncertainty across multiple sectors when economic conditions deteriorate.
And here’s the thing…
Uncertainty about stocks, markets and economic situations can cause demand to pick up in options trading as investors scurry to protect their investments, which inevitably leads to inflated option premiums.
Now here’s the key…
My subscribers receive trade alerts for Straddle trades ahead of rising implied volatility. When the security either rises or falls sharply, the success of the trade is enhanced with rising IV as well.
While you may be following my Straddle trades through earnings season, the concept of this strategy also works well in other circumstances, including the current bond/equity tug-o-war happening right now.
So, as the bond and equity market duke it out, be sure to join me Monday through Wednesday on Money Morning LIVE to find out more about this and other strategies, so you’ll be prepared for your next opportunity.
Until next time,
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