This week the general marketplace is keenly focused on the Middle East as Israel has declared war on Hamas. Many veteran market watchers, including this one, have been surprised the marketplace has not reacted more strongly to the major geopolitical crisis. The Wall Street Journal reported earlier this week that financial markets reacted more strongly to last Friday’s U.S. jobs report than they did, at least initially, to the weekend violence in the Middle East that for Israel was the worst in 50 years.
One respected CNBC commentator summed it up by saying at present the marketplace is not factoring in a further escalation in the Israel-Hamas conflict, meaning no other countries like Iran, Syria or the U.S. will become significantly involved. Many times when unexpected market shocks like this one occur, traders and investors quickly factor into market prices a worst-case outcome, on a knee-jerk reaction. Then, as the worst-case scenario does not play out, market prices begin to retrace their initial big moves. That’s not the case this time.
This veteran market watcher finds it unlikely the Israel-Hamas war will not escalate further and not significantly involve any of the aforementioned countries. To put in simply: The Middle East turmoil is likely to intensify before it de-escalates.
One veteran stock market analyst gave his explanation for the stock and financial markets not seriously reacting (at least not yet) to the current geopolitical crisis: “The Middle East has been turbulent for generations. While the weekend violence in Israel ranks among the worst in the region and is a terrible human tragedy, it is not something new. Traders and investors have had to deal with Middle East instability and violence for decades.”
I don’t place a lot of value on that veteran stock market analyst’s comments. Reason: Human nature has indeed repeated itself throughout the history of mankind, but that does not mean the markets have not had serious reactions to major geopolitical surprises and other big events that have occurred repeatedly through civilization. These repeated occurrences still have caused major disruptions to economies, and impacted trader and investor attitudes.
So what can a trader/investor do if this present Middle East violence does escalate significantly and markets volatility increases dramatically? How can one’s present investments in stocks, bonds and commodities be protected? One way is to purchase (or sell) options on stocks and to purchase (or sell) options on stock index, financial and commodity futures markets. The speculators, who are an important liquidity-providing part of the trading marketplace, can also participate by purchasing and selling options.
In this feature I won’t address the topic of selling options, but the endeavor can be used by experienced and savvy options traders. I also won’t discuss complex options strategies. What I will address below are some simple options purchases for speculators, on the basic notion the Middle East violence will escalate in the near term, to the point of causing higher price volatility in markets and significant trader and investor anxiety in the general marketplace—at least briefly and maybe longer.
–Buy out-of-the-money call options on Comex gold and/or silver futures. Both will rally much more strongly if the Middle East situation turns hotter.
–Buy out-of-the-money call options on Nymex crude oil futures. Crude prices will spike, at least briefly, if Middle East violence worsens.
–Buy out-of-the-money call options on U.S. Treasury bond and note futures. “Flight-to-quality” buying of U.S. debt will be strong on a military escalation in the Mid-East.
–Buy out-of-the-money call options on the U.S. dollar index futures. The greenback will also see flight-to-quality demand.
–Buy out-of-the-money put options on the Euro currency futures. If the greenback rallies, the Euro currency will likely see selling pressure.
–Buy out-of-the-money put options on the U.S. stock indexes. The U.S. stock indexes would sell off sharply if crude oil spikes and investor confidence wilts rapidly on a serious escalation in the Israel-Hamas conflict.
These are just a few ideas on employing options in markets that may become more volatile.
Stay tuned! Jim Wyckoff