Of all the information investors synthesize to determine stock and options prices, corporate earnings are the most valued.
Unlike government data or trade group reports, investors believe corporations are less likely to lie -- and that puts a halo atop quarterly earnings reports.
This rarely remarked-upon fact merits extra consideration as the start of third-quarter earnings season approaches next week. Investors are struggling to understand how muddled economic and political messages integrate into stock prices and implied volatility levels.
The 10-year Treasury yield is now at 5.27% on inflation fears. This is pressuring historically low-volatility equity investments, including dividend-paying stocks, and prompting investors to worry that stocks could come under greater downward pressure.
Goldman Sachs clients' ownership of U.S. equities is at one-, three-, and five-year lows -- the trauma trifecta. At first blush, it's a sign that investors are reducing equity risk as bond yields rise amid mixed inflationary signals. The data also implies better opportunities exist abroad, including Germany, where strong military spending is boosting economic growth.
We don't know what happens next. It's easy to make a case that stocks are poised for a sharp decline, just as it is for them to see a surge or stay in a narrow trading range. In these muddled times, we prefer focusing on a few timeless facts that are easily forgotten when confusion is rampant.
U.S. equities usually rise over long periods. Most investors forget that when the stock market's directional trend is unclear. The lack of certainty -- which deprives investors of the feel-good dopamine hit they get when their portfolios are rising -- triggers emotional decisions. Instead, control your lizard brain and embrace equity risk when the market is morose.
Ahead of this earnings season, options implied volatility is elevated. For options investors, this means puts and calls are inflated with fear and greed premiums. This creates opportunities for a strategy we call "time arbitrage," which uses high short-term options volatility to benefit long-term investments.
When implied volatility is high, as often occurs ahead of earnings reports, long-term investors should consider selling calls or puts on stocks that they want to sell higher or buy lower. After earnings reports, implied volatility tends to sharply decline. (Calls give holders the right to buy an asset at a set price within a specific period, while puts give holders the right to sell an asset within those parameters.)
Consider Mastercard. The stock has been under pressure since Sept. 15, when the 10-year yield crossed 5%, a level that threatens to increase debt payments and complicate financing activity. The credit-card company's decline reflects concerns that higher interest rates will slow consumer spending and travel, which drive Mastercard's earnings. That's a reasonable thesis, but consumers are addicted to overusing credit cards to buy stuff -- and that's a well-established fact. Third-quarter earnings are expected in late October.
With the stock at $565.58, time arbitragers could sell the November $585 call and the November $555 put. The strategy generates $25.10 in premium, and obligates investors to sell the stock at $585 or to buy the stock at $555.
Mastercard stock was recently below key moving averages and poised to test its 200-day moving average of $532.17. Investors have since bought shares and pushed it up. But the stock's technical health is still uncertain.
The drawback to put and call selling is if the stock moves more than expected on earnings news. A put seller could be forced to buy stock at the put strike price even if the stock is far lower. Call sellers limit their upside potential.
Such risks should be acceptable to long-term investors. The strategy, at its essence, commits investors to buying low and selling higher. It's not glamorous, but the only people who think they can catch the ultimate bottom and top have market opinions of no consequence.
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