Like the little birds that come sputtering out of cuckoo clocks at the appointed hour, small investors are following a time-honored script. They’re getting nervous.
As stock prices exhibit some volatility and market commentary becomes increasingly dour, many of them want to ease their anxiety about the markets by popping the financial equivalent of Xanax. To wit: A recent Wall Street Journal article said that investors had put a record $77 billion in funds designed to lower risk.
Some of these funds offer turnkey exposure to low-volatility investments, while others feature embedded options hedges to limit losses to some predetermined drop in the stock market.
There’s nothing wrong with the approaches, per se. But timing is everything.
Institutional investors have been talking about hedging for more than two months. Earlier this year, after the stock market saw its best first-quarter run since 1998, the pros were asking whether this is as good as it gets. John and Jane Investor, meanwhile, never asked the question until fears of a trade war between China and the U.S., and now a potential battle with Iran, began whacking stock prices. (To be fair, most market commentary was breathlessly cheering the strong performance.)
If you expect more severe market difficulties ahead and want an alternative to buying anti-anxiety funds, here’s an inside tip: When institutional investors think the markets are going to convulse, they often buy the stocks of exchanges.
Panic increases trading volumes, the argument goes. Exchanges make money each time someone trades, and they make even more money selling data to algorithmic trading firms that act on relationships and patterns often invisible to the human eye.
President Donald Trump is expected to meet with President Xi Jinping of China at the Group of 20 meeting in late June. If the confab is viewed as exacerbating the trade war, the Cboe Volatility Index, or VIX, will probably surge, and investors may rush to sell stocks to reduce risk, which would influence S&P 500 options and futures trading.
If the saber-rattling over Iran evolves into war, oil prices should increase, and panicked investors would probably sell stocks and run to the safety of cash or bonds.
One of the great qualities about the exchange trade is that the stocks are sharply lagging behind the broad market, though many are trading near their 52-week highs. The market lag reflects low trading volumes, low volatility, and reticence among institutional investors to take on much risk.
CME Group (ticker: CME), which trades futures on interest rates, the S&P 500 index, and West Texas Intermediate oil, is down about 1% this year, compared with the S&P 500’s 12% advance. Cboe Global Markets (CBOE), which trades options on the S&P 500, the VIX, and futures, is up 8%, reflecting interest around volatility and hedging. Intercontinental Exchange (ICE), which owns the New York Stock Exchange and options exchanges—and dominates the Brent crude futures market—is up about 9% this year, and Nasdaq (NDAQ) is up some 10%. ICE and Nasdaq are performing a bit better than peers, largely because of their advanced efforts to monetize trading data.
The implied volatility of exchange call options is a bit higher than the S&P 500, an indication that the options market expects sharper swings in the stocks in the future.
Investors can consider buying exchange stocks or buying upside calls, depending on their conviction levels. Shares are more expensive, and thus more money is at risk if the thesis about trading volumes is flawed.
The options-centric investor should focus on December expirations and strike prices that are slightly above the stock price to capture earnings reports and market seasonality. September is historically the most volatile month of the trading year, largely because investors begin to worry about October, which has historically been the month with the most major declines.
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