Broker Check
Investors Are Growing Wary. 6 Rules for a Nervous Stock Market.

Investors Are Growing Wary. 6 Rules for a Nervous Stock Market.

May 06, 2024

Show me, don't tell me—it's the new mantra for the stock and options markets.

The recent price volatility, which saw market-leading stocks tumble, has changed investor sentiment just as earnings season is accelerating and putting a question mark over stock valuations.

Investors are now wary of economic conditions that could impact 2024 earnings, and less willing to follow unproven trends like artificial intelligence changing the world. They now want earnings data to justify stock valuations. They need evidence that stocks trading at robust multiples merit premium prices when fixed-income investments pay 5.5% or more.

The tension between stocks and bonds is unlikely to lessen while the 10-year Treasury note is yielding around 4.6% and economic data is so strong that it seeds doubt about the Federal Reserve's ability to lower interest rates, as many thought it would this year.

Stock-only investors could well suffer in this environment. Bad news is likely to be multiplied by nervous sentiment. Companies that report bad results—or worse, issue dour forecasts—will likely have stock prices hammered lower. The blowback reinforces our long-held belief that investors might think they own stocks, but they really own volatility and don't know it.

Options-centric investors, on the contrary, should be pleased with the current environment. Uncertainty increases options' implied volatility, often beyond what is merited, and that better rewards options sellers.

Few investors are skilled enough to trade options for the sake of options. This is why it is better for stock investors with deep knowledge of their holdings to use conservative options strategies to enhance returns and reduce risk.

For those investors, we offer a few thoughts that will hopefully illuminate a forward path as others feel their way in the dark.

• Conviction is the master ingredient of investing. If you have conviction, and time, sell cash-secured put options during declines, when fear premiums will be elevated. Similarly, any concerns about stocks that you own and might want to sell can be handled by selling call options when stocks are rallying.

• Don't trade options just because volatility is high and premiums are juicy. Use them to express your views on stocks. Trade puts only on stocks you want to own. Sell calls on stocks you are willing to sell at higher prices. It's that simple.

• No one really knows what is happening. It's unclear if we are about to experience a stock-to-bond regime change if the 10-year-Treasury yield hits 5%—or if the recent stock weakness will prove as ephemeral as most of recent swoons have been. Be reactive, not heroic, until the question is answered.

• Be incremental when you act. Scale into positions. Don't trade all at once. If you want to buy a stock lower, but are worried about falling stock prices, sell five puts at the current price, for example, and then wait and sell another five on another decline and then keep scaling the trade.

• Monitor Cboe Volatility Index (VIX) futures, which determine VIX options prices. The futures suggest that sophisticated investors are uneasy, especially around the presidential election. If you are sanguine, you might be the fool in the great game of probabilities and risk that is the essence of markets.

• Remember: Bad investors think of ways to make money. Good investors think of ways not to lose money.

This Barron's article was legally licensed by AdvisorStream.