It’s a lesson I will never forget.
I was sitting in a junior level class in college as we watched the daily chart of the S&P 500. We weren’t entranced with the market that day because we had an investment on the line, nor was it even for an investment class. This was an economics class.
And the S&P 500 happened to be more telling than the entire 4,000-word research reports we submitted ahead of the opening bell.
That’s because we weren’t watching it for the usual day-trading opportunities, we were watching it for something far more important…
On that day, the Fed was concluding one of its many two-day meetings.
A few weeks before the meetings were to be held, our professor gave us a simple assignment: Predict any significant changes in the Federal Open Market Committee (FOMC) statement.
I spent those weeks leading up to the release analyzing past statements, reviewing the Beige Book and pouring over statistic after statistic until I reached my conclusion — that the Fed would use an improving economy to add language indicating an increase in rates.
Clearly I was wrong.
It’s five years later and the Fed still has yet to raise rates.
But, after all my research, there was one item I didn’t analyze — Wall Street.
At the moment, it seems as though many investors are leaving Wall Street out of the equation as well, and that’s where your opportunity to profit comes — it’s time to buy volatility.
A Blind Eye to Risk
Right now, volatility is sitting at depressed levels, with the S&P 500 Volatility Index (VIX) at a near-term low of just 12.3.
The volatility index, sometimes referred to as the “fear index,” is simply a measure of what option traders are willing to pay for those options.
By nature, options are a form of insurance. Investors use them to hedge risk in the market. With the VIX trading at these depressed levels, it tells us investors are not looking to hedge their current positions — in other words, they are not expecting much action in the markets.
Yet, the Fed has a difficult balancing act on its hands already. Fed Chair Janet Yellen & Co. are attempting to keep the market appeased while maintaining low interest rates in the face of growing debt at the same time as trying to rein in a strong dollar. However, if the Fed tips its hand too far one way or the other, the market could react violently.
By seeing how the market reacts in the seconds after the Fed releases its statement, you can learn just about all you need to know on what was in the release.
For example, if the statement was dovish, the markets would rally. A hawkish statement would create a sell-off. And if the Fed is sending mixed signals, the markets would swing back and forth.
But your opportunity today doesn’t rely on what tone the Fed takes. It’s just based on the fact that the Fed moves the markets and investors haven’t been preparing for that.
Protection for Less
Take a look at this chart of the VIX for the past year (the blue dots represent Fed statements):
It may not seem like it at first glance, but almost all of the volatility in the market today is driven by the Fed. The biggest spike, which happened in October, was from the market reacting to the conclusion of quantitative easing (QE).
You can also notice the chart for the past six months remains highly active, a trend I expect to continue going forward despite the current low levels.
More importantly, I expect to see the VIX surge much higher than it did during its October spike as investors grow more anxious and cautious the closer the Fed moves to raising rates.
With the option premiums so cheap, it’s a perfect time for this stock options strategy. You could either use the lower premiums to add call options, or use it to protect your portfolio from losses by purchasing put options. For those with a higher tolerance for risk, call options on the VIX represent a short-term gamble ahead of the Fed’s two day meeting — plus, we get the first estimate for first-quarter GDP Wednesday morning as well, which should fuel volatility in the market.
The VIX is not actively traded, so instead we will use an exchange-traded fund (ETF) that tracks the VIX — the iPath S&P 500 VIX Futures (NYSEarca:VXX). But, it doesn’t track the VIX perfectly. Since it’s an ETF based on futures contracts, it continually decays in value, so this isn’t a trade you want to hold for an extended period of time.
That’s why I want you to close the position by Friday, May 1. It is an extremely short-term play betting on a spike in volatility surrounding the Fed’s meeting.
Action to take: Buy to open the VXX May 29, 2015 $21 call option (VXX150529C00021000) at the market. At last glance, it was trading for about $1.10.
I back tested these results for the past year to get an idea for your risk versus reward picture, and in two cases you stood to bank gains of 190% and 240% in just a short week. In other cases, your losses ranged from 35% to down more than 60%.
Considering investors seem to have forgotten the lesson I learned five years ago on how Wall Street reacts to the Fed, I think today is the perfect time for this stock options strategy.
Editor, Pure Income