Text size

After a certain age, everyone accepts that they will have only a small number of close friends. An active life competes with the time needed to develop deep friendships.

Nevertheless, many people act as if they have a deep knowledge of the stock market, which is larger, and far more complicated, than any social circle.

More than 6,000 stocks are listed on U.S. equity exchanges, spanning 11 main sectors. Those stocks are affected by other markets—including derivatives, debt, and commodities—that are invisible to most people. A towering intellect is required to speak meaningfully about complicated ecosystems. Yet investors are often overconfident when assessing what they think they know. And overconfidence is one of investing’s deadliest sins.

Each day, some pundit or sell-side seer speaks with great authority about what the market is thinking and will do. The more complicated the matter, the greater the confidence. The market thinks the Federal Reserve will raise interest rates less aggressively. The market thinks inflation has peaked. The market thinks it’s so big and powerful that nothing will impede its inevitable rise.

Now seems like a good time for investors to make sure that they aren’t too confident.

The options market’s fear gauge, the

Cboe Volatility Index,
or VIX, is around 19, a level that suggests neither fear nor confidence about stocks over the next 30 days. Even this is an illusion.

Out of sight of most people, some institutional investors are aggressively preparing for a major stock decline. They are consistently buying VIX call options that would increase in value if the VIX spiked and the

S&P 500 index
plummeted.

Recently, Susquehanna’s Chris Jacobson advised his clients that an unnamed investor bought about 130,000 March $24 VIX calls and about 165,000 March $26 calls.

When stock prices surge, even if it’s far more than normal, few investors complain. They are happy to make money, a phenomenon we call “socially acceptable volatility.” When stock prices plummet, however, volatility is bad. No one likes losing money.

Only a handful of investors recognize that unusually strong moves in either direction that defy the normal tempo should be looked on with trepidation. What’s the response in such a situation? Something nonheroic that doesn’t dramatically increase risks while potentially monetizing a potential next move up or down.

Consider

Interactive Brokers

Group (ticker: IBKR). In early December, we opined that the electronic brokerage firm’s stock was poised to hit a record high price, which recently happened. The company remains well positioned, as it should benefit from the overconfidence and simmering volatility in the stock and options markets.

With Interactive Brokers stock around $86, the March $80 put could be sold for about $1 and the March $90 call could be bought for about $1.85.

The so-called risk reversal—that is, selling a put and buying a call with a higher strike price but a similar expiration—positions investors to buy the stock at $80 while allowing them to profit from any gains above $90.85 (the strike price plus the cost of the trade).

The risk to the approach is if the stock sharply plummets below the put strike price. If that happened, investors would have to buy the stock or adjust the put to avoid assignment.

The move expresses confidence in a company that is well positioned to benefit from extreme volatility caused by what looks like a first-quarter episode of investor overconfidence and socially acceptable volatility.

Steven M. Sears is the president and chief operating officer of Options Solutions, a specialized asset-management firm. Neither he nor the firm has a position in the options or underlying securities mentioned in this column.

Email: [email protected]