The S&P 500 ETF (NYSEARCA:SPY) is nearly 10% off its highs, and Wednesday’s Federal Reserve announcement did little to help. But rather than fight the tricky backdrop, I suggest you embrace it using an iron condor on the SPY exchange-traded fund.
The highest inflation readings in decades all but demanded the central bank strike a more hawkish tone. And they did. Their statement reinforced the Street’s forecast for four interest rate hikes this year. As a result, investors are re-pricing equities, and high volatility is proving sticky.
Iron Condors are a popular options strategy well suited for times like these. They allow you to avoid making a directional bet (which is hard right now) and capitalize on market volatility instead. The elevated market uncertainty is increasing the potential payday and the margin of error.
To set the stage, let’s look at just how much volatility has risen.
Volatility and the SPY ETF
Those hoping for Jerome Powell’s press conference to speak peace to stocks and inject some much-needed calm must be disappointed. Thus far, we’ve seen no let-up in volatility.
Overnight gaps have become commonplace, requiring traders to sleep with one eye open. The Street’s go-to gauge for measuring volatility is the CBOE Volatility Index (CBOEINDEX:VIX). It just climbed seven consecutive days for the first time since the 2016 election. The streak ended on Thursday, but only barely.
For the uninitiated, demand for options on the S&P 500 is the driver behind VIX movements. When fearful traders dash into the derivatives market to purchase put options, it inflates premiums. That, in turn, drives up the VIX and sends a clear message that anxiety is on the rise and panic in the air.
Traders schooled in the art of contrarian thinking use indicators like this to identify when it’s worth fading the crowd.
As the sage Warren Buffett has said, “You want to be greedy when others are fearful.”
Of course, for today’s message, I’m more interested in the fact that a stretched VIX has historically signaled prime times to sell options. Pumped-up premiums increase the allure of all options trading strategies like the iron condor.
But that’s not the only reason supporting this particular play. The SPY ETF chart is messy enough to make rangebound positions more tempting than picking a direction.
To make a case for rangebound behavior, let’s use the process of elimination to rule out a bullish or bearish bias for SPY.
First, this drop is more than just a flesh wound. We’ve cracked all major moving averages and now sit submerged beneath the pivotal 200-day moving average. Each attempt to climb back above the 200-day has been rejected and is an important reminder of just how much resistance looms overhead. That makes it hard to bet on bulls here.
But that doesn’t mean bears have an easy path forward either. Price has become extremely oversold, making swift snapbacks a real possibility. Just look what happened on Monday when the SPY ETF closed green on the session after being down 4% midday.
Either way, directional trades seem more treacherous than gaming volatility.
The Iron Condor
The iron condor consists of selling a bull put spread, and a bear call spread simultaneously. You use shorter-term options to capitalize on the higher rate of time decay. And, you use far out-of-the-money options to create a wide profit range. With the VIX as elevated as it is, we can build a position with a much wider range than usual.
The Trade: Sell the March $380/$375 bull put and $469/$474 bear call for $1.00.
Consider it a bet that SPY remains between $380 and $469 for the next 50 days. The options will expire worthless if it does, allowing you to pocket the $1 credit. The max risk is $4. If you want to increase your odds of success further, you could exit once you’ve captured 50 cents of the potential $1.
On the date of publication, Tyler Craig did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
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