Riding the Volatility Wave: A VIX-Based Approach to Election Investing

Here's the Real Reason Treasury Yields Are Rising (YouTube link)

Yield Curve Mystery: Why Did Yields Rise After the Fed Cut?

The speakers in the video above are discussing the recent rise in the 10-year Treasury yield following the Federal Reserve's 50-basis-point interest rate cut. They propose four potential explanations for this unexpected yield increase:

1. A Head Fake: The yield rise is temporary and will soon reverse.
2. Bond Vigilantes: Investors are concerned about rising deficits and national debt, leading them to demand higher yields on government bonds.
3. Market Repositioning: Investors who had bet on a recession are now selling bonds as the economic outlook improves.
4. A New Market Paradigm: Investors are anticipating higher growth and inflation in 2025, leading to increased demand for higher-yielding bonds.

The speakers from DataTrek Research lean towards the third or fourth explanation, suggesting that the market is shifting towards a new paradigm of stronger economic growth and higher inflation. They also acknowledge the possibility of a Fed policy mistake, given past errors in assessing economic conditions.

Current bond yields are similar to those seen in the 1960s and 2000s

Nick Colas from DataTrek Research  is arguing that despite significantly higher debt-to-GDP ratios compared to the past, current bond yields are similar to those seen in the 1960s and 2000s. This suggests that the market is not yet pricing in the risks associated with increased government debt. The speaker believes that factors like inflation expectations and real interest rates are more significant drivers of bond yields than debt levels. They argue that the current market environment is not indicative of an imminent debt crisis, and that the market is not yet fully pricing in the potential consequences of high debt levels.

How to Ride the Volatility Wave

In the video above (from @29:13 to @30:59), Nick Colas and Josh Brown discuss the VIX chart shown to clients, emphasizing potential volatility from the upcoming election.

CBOE Volatility (VIX) Index (10/2020 - Present)

Despite stable expectations, they acknowledge that surprises can happen. Historically, a VIX at 35 signals a good buying opportunity for the S&P 500, with an average gain of 6.5% over the next month. A VIX at 27 is also a useful indicator. They stress that these levels help in deciding when to buy amid market volatility, drawing on strategies used since the pandemic crisis. They're cautious but wouldn't be shocked to see the VIX hit 30 again.

Key Points

They're warning about potential market volatility ahead of the election. They suggest using these levels to buy stocks when the market is volatile.

• Historically, a VIX at 35 signals a good buying opportunity for the S&P 500, with an average gain of 6.5% over the next month.
• A VIX at 27 is also a useful indicator.

Understanding Options Contracts

How To Choose An Options Contract (YouTube link)

The above video offers a basic overview of options trading, focusing on key factors when choosing an options contract. Consider the various expiration dates available. The choice depends on your trading strategy. For weekly trades, focus on the nearest expiration. For swing trades, opt for a later expiration date based on your expectations.

Key Points:

• Platform: The speaker recommends Interactive Brokers Pro (IBKR Pro) for its fast execution speeds.
• Options Chain: This is the interface where you view available options contracts.
• Key Metrics: The most essential metrics include last price, net change, delta, open interest, volume, theta, bid, and ask.
• Delta: Measures the sensitivity of an option's price to changes in the underlying asset's price.  In other words, delta shows how much an option's price changes for each $1 move in the underlying stock. 
• Relationship between option price sensitivity (delta) and premium: Note that options with higher deltas, indicating greater price sensitivity, generally have higher premiums. Conversely, options with lower deltas, indicating less price sensitivity, typically have lower premiums. This is because options with higher deltas are more likely to be profitable if the underlying asset's price moves in the desired direction.
• Open Interest and Volume: High open interest and volume indicate liquidity, making it easier to buy or sell contracts.
• High open interest indicates that many contracts are available, while sufficient volume ensures there are buyers and sellers to facilitate trades. Without enough volume, even a profitable option may be difficult to sell. This is because options are traded in an open market, and finding buyers or sellers is crucial for successful trading.
• Theta: Theta represents the time decay of an options contract, meaning its value decreases over time. Theta decay gives traders an idea of how much the value will drop overnight or in a single day.
• Spread: The difference between the bid and ask price.  Aim for options with narrower spreads to minimize transaction costs and improve profitability.
• Wide spreads can significantly impact profitability, as the difference between the bid and ask price can result in immediate losses. This can be particularly problematic when using stop-loss orders, as the wide spread can trigger the stop-loss before the desired price movement occurs.

Choosing Contracts Based on Theta:

1. Trading Horizon: If you're a short-term trader, focus on options with lower theta values to minimize the impact of time decay. Conversely, if you're a long-term trader, you may be less concerned about theta.
2. Underlying Asset Volatility: High volatility can offset the effects of theta decay. If you expect the underlying asset to be highly volatile, you may be able to tolerate a higher theta.
3. Risk Tolerance: Consider your risk tolerance. Options with higher theta values tend to have lower premiums, but they also decay faster. If you're risk-averse, you may prefer options with lower theta values.

Example:

• Short-Term Trader: If you're trading weekly options, you'll want to choose contracts with lower theta values to minimize the impact of time decay.
• Long-Term Trader: If you're holding options for several months, you may be able to tolerate higher theta values, as you have more time for the underlying asset's price to move in your favor.

Remember: Theta is just one factor to consider when choosing options contracts. Other factors, such as delta, implied volatility, and strike price, should also be taken into account.

Additional Tips:

• Focus on essentials: Start with the most important metrics and gradually add more complexity as you gain experience.
• Avoid noise: Avoid overwhelming yourself with too much information. Focus on what's relevant to your trading strategy.
• Consider liquidity: Ensure there's sufficient open interest and volume to avoid difficulty in buying or selling contracts.
• Be mindful of spreads: Wide spreads can impact your profitability.

By understanding these key concepts, you can make more informed decisions when trading options.