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Coronavirus Causes a Volatility Spike. Time to Sell Options?

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The spread of the Coronavirus has the global financial markets spooked. Although the possibility of a significant outbreak has been in the news for pretty much all of 2020, equity markets basically ignored the threat until about a week ago. Once investors started to get a taste of all the ways that the panic about a possible global pandemic could affect actual financial results in a wide range of industries, well…all hell broke loose.

First, take a deep breath.

I don't know the future, so I can’t guarantee that the response has become an overreaction but past experience would suggest that by the time large groups of people start doing things like avoiding contact with others, wearing surgical masks for protection and selling their stocks, we’re close to out of the woods.

In what could be considered to be a defect in human evolution, we tend to be bad at assessing risk. People tend to focus on immediate, obvious and serious potential threats, even when the probability that they’ll actually suffer an adverse outcome is infinitesimal.

Right now, the best available scientific evidence suggests that the virus isn’t really all that dangerous, killing less than 2% of known infected patients. Most young, healthy people who are exposed have only minor symptoms – or none at all – before recovering entirely. The vast majority of fatalities has been among people who are very old and/or have a complicating health condition.

But…

Even if the current level of panic is disproportionate to the actual threat to the average person (especially in the US, where there have still been only a handful of diagnoses) the damage to global commerce and corporate earnings could be quite real. If people stop buying goods and services from each other and stop going to work to produce those goods and services, global GDP will suffer.

The effect is likely to be seen first in the results of companies that have immediate exposure like airlines and travel companies, but could spread to virtually all industries. It doesn’t matter if the actual threat from the virus is overblown, the financial impact will be real.

That’s the bad news.

The good news is that the long-term effects of the virus are likely to be fairly small.

“Buy the dip” certainly sounds easy once the panic has abated and we’re patting each other on the back for having scooped up shares at a steep discount, but when it actually happens, it doesn’t feel good.  It feel awful. Terrifying.

It can be a little bit less uncomfortable if you feel like the odds are on your side.

On Thursday, the CBOE Volatility Index traded above 32%. Options on individual stocks are even higher as investors scramble to buy protective options.

If you’re feeling (as I am) that it might be time to start buying some stocks that have been beaten down over the past week, now is the perfect time to sell puts.

Everyone wants to pick the bottom of any given move in equities to make a well-timed buy, but in practice, it’s almost impossible. But you can be assured of either buying cheaper than the current price or else get paid for merely being willing to.

If you have some dry powder on reserve but you’re not sure that this is the right level to buy a stock that’s on sale or even a whole index, pick the price below the market at which you’d be happy to go long and sell the puts with a strike at or near that price.

If the price of the underlying continues to go lower, you’ll be buying at a discount to today’s price. If stocks stop sliding and stay here or recover, you’ll have a nice pile of cash to show for your efforts as the rest of your portfolio recovers from the Coronavirus shock and the value of your short puts goes to zero.

Successful trading – especially in options – depends on skewing the odds in your favor. When someone is bidding 32% vol for index options, they’re effectively skewing those odds for you. You just have to have the intestinal fortitude to take the other side of the bet.

-Dave

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