The Iran war may soon be over, but financial risk lives forever.
Investors are thus advised to be cautiously optimistic in response to news reports and market rumors that Iran's president has dramatically changed his mind about ending the war.
The stock market has surged on expectations that a peace deal may emerge between Iran and the U.S., but it is hard to determine if something substantive has occurred, or if investors are getting ahead of themselves.
The price of oil remains elevated, despite peace talk reports, which suggests that issues around the control of the Strait of Hormuz remain murky at best. The same is true about Iran's nuclear weapon capabilities, which President Donald Trump has cited as a key reason for commencing military action.
Even though the stock market has surged, and the Cboe Volatility Index, or VIX, has declined from its recent highs, investors should be wary of reading too much into the move. Diplomatic negotiations are hard to trade with any precision as each side jockeys for advantages at the deal table.
The options market remains cautious toward stocks.
The VIX is still elevated at around 25, a level that implies the S&P 500 index will move an astonishing 1.6%, up or down, each day over the next 30 days. The VIX's long-term average is about 19, so the current level is far from telegraphing a bullish signal about equities.
Barring concrete statements from Iran's leaders, or Trump, we continue to believe that the best next step is to let more information flow into the market, and to then make decisions.
The environment is simply too uncertain for anyone to conclude that they must buy stocks for fear of missing out. If you cannot fight FOMO, and you are one of those investors who remains addicted to action, options are a legitimate alternative to stocks.
Sure, implied volatility, which is the essence of put and call prices, remains expensive, but options cost less than stocks. This enables investors to risk less money while still positioning for gains.
Our preferred approach for aggressive traders who have the resources is to implement a risk-reversal strategy. This entails selling a put and buying a call that has a higher strike price but a similar expiration date.
The put sale positions investors to buy stocks lower, while the call increases in value if stocks advance. The risk to the strategy -- and it is hard to overstate it -- is that stocks will plummet should reports of peace prove false.
You can use this strategy on just about any stock, exchange-traded fund, or index. The pieces fit together the same way. We will illustrate the strategy with the State Street SPDR S&P 500 ETF (ticker: SPY).
The ETF, like the S&P 500, is a proxy for the world's top companies. When investors want to express a view on the trajectory of the world's financial markets, they often use the S&P 500 because its constituents derive so much revenue from international operations.
With SPY at $650.34, aggressive investors could sell the April $633 put that expires April 17 for about $7.21 and buy the April $660 call that expires April 17 for the same price. The trade essentially gets the options market to pay investors to speculate that the ETF will be above $660 on April 17. In return for receiving those generous financing terms, investors are obligated to buy it at $633 or lower.
If you have conviction that the war will soon be over, this trade puts you in a sweet spot. Should the war rage on, well, stocks rise over the long term -- though that will be of little solace if equities reverse their recent relief rally.
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