Conquer Your Fears of Volatility Once and For All
I’ve been warning Profit Catalyst Alert subscribers for some time that volatility has been lurking beneath the surface of the market. Stocks, in particular retail, banking, and drug stocks, were dropping despite beating earnings estimates yet the S&P hit new highs daily.
Mid-July, JP Morgan (NYSE: JPM), Citicorp (NYSE: C) and Wells Fargo’s (NYSE: WFC) stocks declined 1-2% despite beating estimates. Drug manufacturers Merck (NYSE: MRK) and ANI Pharmaceuticals (NSDQ: ANIP) beat estimates by 15% on average. Their stocks initially jumped higher only to be swamped with selling and close down. Long time beaten-down retailers Macy’s (NYSE: M) and Nordstrom’s (NYSE: JWN) both announced better than hoped for comp sales yet suffered messy sell-offs.
All the while, armchair investors took comfort in a docile VIX. The CBOE VIX index measures the volatility in the stock market. A three-month chart of the VIX resembles the plains of Illinois. The VIX has hovered within a two point range since mid-May.
A recent article in the Wall Street Journal explains the divergence between the VIX and individual stocks. The VIX measures jerky action in the overall S&P index, not in single stocks. Investors have been migrating from one stock sector to the next. The buying in one group offsets the selling in another, creating the illusion of a perfectly calm market.
Post election, industrial and building stocks boomed upward while retail and consumer good stocks sagged. Bank stocks rocketed upward on the hopes of widening margins and drug stocks collapsed on fears of price controls. It is unusual for so many different industry groups to see their correlations unravel.
Underneath the flat-lined VIX, chaos has been building like a coiled spring. It took a draconian semantic war between President Trump and North Korea’s Kim Jong-un to release that pent up volatility. Up until last week, the market withstood threats of sanctions, tax cuts, and a possible health care overhaul but the chance of a nuclear missile strike was too much for investors to take.
I knew the tension was bubbling up without analyzing these individual charts. A quarter century plus of analyzing stocks builds up a six sense of investor nervousness. When the correlation between earnings beats and stock movement begins to unhinge, there’s something afoot.
That something is usually jittery fingers perched above the sell button. Let’s face it; the market has risen steadily upward despite escalating political and fiscal uncertainty. Before last week the S&P had gone 58 days without a move bigger than 1%.
The market is not cheap. The S&P is trading with a price to earnings (P/E) ratio of 25 times versus a long term average of 15. Investors are looking at a slow and steady rise in interest rates, a notorious hobgoblin for stocks. Uncertainty regarding government policy regarding health care, taxes and trade agreements has left investors unable to evaluate some pretty important risks for stocks.
But fear not, volatility can be your friend if you know how to play it right. Increased volatility is one of the basic ingredients that boost option prices. Jim Fink, editor of Options for Income and Velocity Trader, is the reigning king of options trading here at Investing Daily. He’s fine tuned his trading to make money in options regardless of market volatility.
I’m no option expert, so I’ve been focusing on the straightforward buying of puts and calls on stocks. The basic bullish or bearish premise for each trade rests on rigorous stock analysis. The most critical element for these options trades to be successful is to have the stock price move in the right direction. However, rising volatility helps to goose option prices.
In just the last three weeks Profit Catalyst Alert closed out three option trades for gains between 100-250%. Two were bearish put purchases and one a bullish call. As noted above, a helpful factor in these huge gains was a correct bet on the underlying stock price, but volatility helped a bit. Just as the price of insurance rises with a hurricane, option prices (an insurance policy on stocks), rise in tandem with uncertainty.