Spotlight: What to Buy If Things Get Crazy Soon

Among the first lessons any great investor learns is “Don’t Fight The Fed.” Simply put, it means when the Fed is accommodative and engaging in quantitative easing, money is cheap and economies boom. Some call this the Fed Put because as markets fall, the Federal Reserve acts swiftly to provide liquid support by buying bonds.

Equally when rates rise, it’s akin to the Fed “selling calls” meaning that it’s aiming to cap the upside on markets. Rate hikes slow economic activity because a huge portion of money is actually just debt, and so the cost of borrowing rises as the Federal Reserve increases rates.

Naturally, there is a slowdown in projects as returns on investments decline. Fewer corporate initiatives, building developments and so on all converge to produce a slowdown.

Right now, the Fed’s policy has shifted from providing that Put to selling the Call, meaning it’s on the side of capping equity markets. It’s hard to believe it, though, when you see markets at all time highs. So what explains the difference?

Key Points

• The Federal Reserve has shifted from providing a virtual put under share prices to essentially selling calls to cap them.
• Seasonal flows will soon subside and the odds are bearish flows and macro realities will once again re-surface.
• If volatility spikes, the VXX offers a lot of upside potential for volatility speculators.

The Big Picture Is Scary

Bullish seasonal flows have dominated in recent months as enormous levels of new equity have been created and re-collateralization has come to the fore. But under the surface, bearish macro flows have persisted, they just haven’t overwhelmed the seasonal flows.

As the calendar marches on the bullish flows start to dissipate ever more, expect macro flows to dominate once again. And when they do, volatility should rise.

So how do you play a spike in volatility?

How To Bet On Volatility

For anyone who has dabbled in buying VIX options, the dangers are well-known but few novices are aware of them. That’s because VIX options are not based on the spot but on VIX futures. So if the VIX spikes but the futures are betting on a return to lower levels, the options may not go up much at all. It can be frustrating to get the direction and timing right as options require and still not make money because of this spot versus futures nuance.

Instead, an alternative is to select the VXX, which acts as a proxy for the VIX. If volatility does rise in 2024 then it’s quite likely to spike a lot more than most investors expect. Often market lows have coincided with the VIX spiking all the way up past the 50 threshold and beyond.

For investors buying the VXX, the returns can be astronomical at those times, but arguably they are even better for put buyers because not only do puts rise in value as prices fall but volatility goes up too, further elevating the value of the options.