Is inflation done, or is there more coming?
Stocks have had a dreadful 2022. A mostly unanticipated and stubborn surge in inflation triggered the Fed to tighten, hiking rates, and unwinding its asset purchase programs.
What investment strategy works to avoid having to choose?
A straddle-based strategy allows investors to profit from either a rapid rebound or a deeper sell off, avoiding the need for a directional choice.
The big question is: Will inflation turn the corner, or will it linger?
What could go wrong with this type of strategy?
The strategy provides investors with expected gains from a major market movement, regardless of its direction, but it will not perform well in sideways trading. As is common with a straddle, the potential loss is up to 100% of the invested capital.
If the invested amount is $1,000 and the stock market fails to “sink or swim” more than 5% by September 30, the potential loss is the entire $1,000.
One possible strategy involves opening a straddle 5% above and below the current SPY price as follows:
- Buy a call option contract with a strike 5% above the current SPY price.
- Buy a put option contract with a strike 5% below the current SPY price.
This combination allows investors to buy or sell the SPY at fixed prices. Therefore, generating a profit if the SPY moves more than 5% from today’s levels in either direction.
To defray the cost of the straddle above, the strategy includes selling a straddle 10% above and below the current SPY price, including.
- Sell a call option contract with a strike 10% above the current SPY price.
- Sell a put option contract with a trike 10% below the current SPY price.
This caps the total return, but materially reduces the required invested capital and potential loss.
Example Thesis and Timing:
The market’s outlook could be significantly clarified over the next 4-6 weeks through announcements related to:
- Inflation and employment/wage related data.
- Housing market, consumer spending, and other early indications of recession risks.
- Global oil and US gasoline prices.
- FOMC rate announcements and policy guidance (next meetings are schedules for July 26-27)
- US dollar strength v. the Euro, Yen, and GB Pound.
Depending on the direction and intensity of this news flow over the summer, particularly around the next Federal Open Market Committee (FOMC) July meetings and its rate policy announcements, the market’s consensus could move dramatically either way.
- If the economy lands softly, it is likely earnings estimates are ratified, multiples expand, and equities rebound, or
- If the economy is still slowing down and inflation remains high beyond 2022, equities are likely to continue rolling downhill.
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