(Barrons: Steven M. Sears)
When VIX is high, it’s time to buy. When VIX is low, it’s time to go. When VIX is flat, sell calls against that.
If you remember that trading ditty—which we have tweaked for 2023 in anticipation that extreme moves up and down in the stock market will give way to stretches of sideways trading—you
should have a reasonable action plan for the new year.
The Cboe Volatility Index VIX +2.74%, or VIX—the so-called fear gauge—is a useful
tool for framing what is likely to be an erratic year for investors.
Everyone knows that the Federal Reserve has ended the easy-money policies that
helped propel stocks ever higher for the past two decades. But no one really knows
what happens next following a series of aggressive interest-rate hikes that were
intended to tamp inflation.
There is considerable disagreement around the Fed’s ability to engineer a soft landing
by raising rates to slow inflation without pushing the economy into a recession and
thus walloping the stock market.
If a recession occurs in the first quarter, it would probably presage lower corporate
earnings, which would lower stock multiples—and that, in turn, would drive down
stock prices and push VIX higher.
Despite dramatic differences of opinion about how the market will behave next year,
few people have experience dealing with the financial conditions and interest-rate issues that now confront us—and that probably portends more volatility.
Next year is likely to be a strange amalgamation of known unknowns (Fed rate hikes
whose size is hotly debated) and unknown unknowns (how they express themselves
in the market and economy).
All that means is that investors should expect an erratic, choppy market as rate hikes
affect the economy. Such conditions tend to favor options investors. It also makes VIX a
useful contrarian indicator. Or, to put it another way: When VIX telegraphs extreme fear,
think about being bullish, and vice versa.
When VIX is above 30, it suggests that investors are more bearish than bullish and that
they are buying put options to hedge against stock declines. Bullish investors could
sell cash-secured puts to monetize that fear and profit from a potential snapback rally.
When VIX is below 19, it suggests that investors are complacent—or at least not
mindful of market risks—and that any stock rallies are likely to run out of steam. If VIX wanders between, say, 18 and 24, it probably suggests that investors are unsure of what to make of the passing scene. A low VIX reading could favor buying defensive puts to hedge stocks or portfolios or even selling call options to enhance yields on stalled stocks.
The market mob almost always overreacts. It is that overreaction—the panic that sets in
when VIX spikes, or the confidence about the future when it falls—that creates conditions for the opposite to happen.
The mystery of what comes next should lead to a resurgence in stock-picking and
cause some investors to move away from an overreliance on index funds. If a rising tide
no longer lifts all ships, investors will try to find the ships that have some race in them
Because it’s riskier to pick stocks than to pick hot sectors, the appeal of equity call
options that expire in six months or more is likely to increase—despite the higher cost
of a longer time premium.
Of course, we could be wrong about the erratic nature of 2023’s stock market. Even so,
using options to buy fear and sell confidence while selling calls on stalled stocks is
unlikely to harm investors over the long run.
Steven M. Sears is the president and chief operating officer of Options Solutions, a
specialized asset-management firm. Neither he nor the firm has a position in the options
or underlying securities mentioned in this column.