When considering the timing of rate cuts by the Federal Reserve, it is important to question whether it truly makes a difference if interest rates are not expected to increase. This question arises in light of the market’s overreaction to Fed Chairman Jerome Powell’s recent statement on potential rate cuts during a 60 Minutes interview.
Despite our earlier prediction in January, the market has chosen to selectively hear what it wants to hear. However, it has failed to acknowledge a crucial fact: both the stock market and the economy are thriving even with the 10-year Treasury note yield above 4%.
Moreover, we are currently in the midst of earnings season, and reports indicate favorable results for many companies, with some performing exceptionally well. Investors seem pleasantly surprised by the robustness of corporate profit margins and the existence of dedicated executive teams focused on enhancing profitability.
Furthermore, recent economic data has exceeded expectations, demonstrating the impressive adaptability of the economy to withstand higher interest rates. It is as if the economy has evolved into a weightlifter who emerges stronger through a rigorous training regimen.
These are indisputable facts. Notably, price volatility is advantageous for stocks, particularly when indexes are approaching record highs.
Even when stocks experience a gradual decline without panic, like what occurred earlier this week, it actually benefits both the stock and options markets. Traders refer to this type of situation as a “two-way flow,” which brings together natural buyers and sellers.
The temporary weakness in prices clarifies investor sentiment and often leads to increased options volatility. This is due to investors purchasing bearish put options when their bullish views face challenges, subsequently causing an increase in implied volatility.
Therefore, we should perceive the recent stock market turbulence as a reaffirmation of the effectiveness of an options strategy that we have long referred to as “time arbitrage.”
Taking Advantage of Fear in Stock Investing
When stock prices weaken, long-term stock investors can take advantage of short-term fear by selling cash-secured puts on favored stocks—a strategy that requires investors to have the money to buy shares at the strike price. This enables long-term investors to monetize the fear of other investors. Scared investors often rush to buy puts, usually paying too much to hedge. They become insensitive to price, and that is what makes the time arbitrage strategy so enticing.
Building a Strategic Stock List
To effectively utilize this strategy, investors should have a list of stocks they want to own or buy more of. Additionally, it’s important to take note of investment themes that represent key trends shaping the world around them, such as artificial intelligence, the aging of America, the rise of private financial markets, and healthcare innovations.
Seizing Opportunities During Market Panics
When the market mob panics, time arbitragers can enter orders to sell cash-secured puts to fellow investors who will pay just about any price.
In most cases, the burst of fear subsides within a day or so, and the stock price bounces higher and settles above the put strike price. This means that anyone who sold puts gets to keep the money they received for selling the contract. The worst-case scenario is if the stock falls below the put strike price, but even then, the put seller gets paid by the options market to buy a stock they wanted to own anyway.
Consider an Example: Equinix
Let’s consider the example of Equinix, a data-center operator that is benefiting from rising demand from corporations needing storage space for their servers and related equipment.
With the stock currently priced at around $838, investors could sell a cash-secured March $760 put. If the stock remains above the strike price at expiration, investors keep the put premium. If the opposite happens, investors must either buy the stock or roll the position to avoid the obligation.
The Value of Time Arbitrage
Time arbitrage not only allows investors to take advantage of fearful market conditions but also creates order in moments when little exists. Additionally, it keeps investors aligned with the merits of buying quality stocks when they are mispriced.