Options Arena: The Next Black Swan
Imagine if you knew COVID was coming in February 2020…
Or foresaw the collapse of the U.S. housing market in 2007…
Or even that the Dow would crash 23% on October 19, 1987?
Each of these events has been described as a “black swan.” Coined by Nassim Taleb, it signifies a sudden, severe, and largely unexpected event that roils financial markets.
Emphasis on the “largely.” Plenty of investors have made legendarily profitable trades as these chaotic events unfolded.
Just by looking well ahead of the crowd, and listening close to the quiet rumblings beneath the drone of noise…
Today in Options Arena, we attempt to do the same.
Our True Options Masters will each share their predictions for next year’s big headlines — and help you position your portfolio for them.
We make no concessions to the permabulls among you.
The world is at a turning point, and we as investors must prepare for more volatility, not less, over the next several years.
That said, let’s see what Mike, Amber, Adam, and Chris think is in store for August 2023…
Mike: This Winter Will Be Devastating for Europe
Europe faces another devastating winter. That should be the headline now. It will certainly be the headline next August.
Historically, bad winters drive change in Europe.
In 1946, a German woman summed up her living conditions: “Life is not fit for pigs anymore.” The same was true throughout Europe after six years of devastating war.
The next year would prove to be even worse, described as “the winter of power cuts, no TV or baths and children sent to bed without dinner because there wasn’t enough food.”
Finally, in 1948, Europe recovered with the aid of the Marshall Plan.
Now, once again, there is war in Europe. But this time, the consequences will be even more far-reaching…
During the long peace, European countries became integrated. Many depend on Russia for natural gas to power their economies. That supply is now threatened, and there’s no quick fix. It takes years to build infrastructure. Current efforts, like Germany’s law mandating thermostats in public buildings be set to 66 degrees or less, are likely to be ineffective.
Growth is slowing as inflation rises. That means Europe faces stagflation. And there won’t be a Marshall Plan this time around, because the U.S. can’t afford it.
The trade for this looming black swan is puts on SPDR EURO STOXX 50 ETF (FEZ). January 2024 $35 puts are trading at about $4. They should be profitable if FEZ falls 11%. With European stocks likely to drop more than 20% over the next year, this option could double.
Amber: The Recession Will Ruin This Sector
Next summer, we’ll be talking about the recession that is dragging on.
Unemployment will be close to 6%, with inflation stubbornly stuck near 5%. GDP data will show the economy is contracting, and economists will finally agree the recession is underway.
Consumers will cut back — but after more than a year of the same, there won’t be many easy cuts left.
Families will feel the pain of being unable to afford summer activities for their kids. Back-to-school shopping on tight budgets will deepen the feelings of gloom. On the other end of the aisle, seniors will wonder when they’ll finally see lower prescriptions costs promised by Congress (and learn that it’s not until after 2025).
Tax receipts will fall in local communities as services are cut back. Crime will continue to rise. Some cities may even feel like a scene in Mad Max.
And all that gloom will show up in struggling stocks. The hardest-hit sector is sure to be retailers. Many consumers just don’t have money to spend. Those that do are worriedly saving, preparing for more bad times ahead.
SPDR S&P Retail ETF (XRT) is likely to be much lower than it is today. The ETF could retrace all of its bull market gains and trade in the high $20s by next year. That makes the January 2024 $65 puts attractive. Even though they cost about $10 now, they could more than double as XRT crumbles.
Adam: This Wall Street-Level Strategy Is Up 33%
Okay, so first…
I ascribe to Nassim Taleb’s definition of so-called “black swans.” That is, events that are:
So rare or statistically improbable that they cannot be predicted (or even imagined, in most cases)…
Cause severe consequences…
And tempt folks into thinking they were obvious or foreseeable, in hindsight.
To me, the first of those criteria is the most important. True black swans cannot be predicted.
If you proceed with that assumption, you have two routes to consider, in terms of lining up trades that will either survive or thrive during future black-swan events.
The first route involves buying options. For one, long options offer a favorable trade-off between risk and return: risk is limited and defined at the onset of the trade, while potential returns are unlimited… and can be many orders of magnitude the cost of the option. We call this “convexity.”
Of course, you don’t know where the next black swan will appear, nor how it will manifest in the price action of various financial markets.
The next black swan could cause oil spikes to triple… or fall by 90%.
It could affect one particular sector of the U.S. stock market… or all stock markets globally.
It could be a currency-markets event… or a bond-market catastrophe.
And that makes buying options, as a means toward protecting against (or profiting from) true black swans, so difficult. You have to predict a lot — which market will be affected… whether it will cause prices to rocket higher or tank… and whether or not the event is already priced into the trade you’re buying.
The second route is to allocate to a diversified, multi-asset trend-following strategy. One that makes trades in dozens if not hundreds of individual markets, within the four major asset classes: stocks, bonds, currencies, and commodities.
And, of course, one that is able to go both “long” and “short,” to benefit from rising and falling prices.
This strategy is the stalwart of the Commodity Trading Advisory (CTA) industry, which you can think of as hedge funds that trade futures contracts. In recent years, the strategy has become accessible through mutual funds and ETFs.
One such fund is the AQR Managed Futures Strategy (AQMIX), which is up 33% in 2022 — a year in which the holy-grail “60/40” portfolio is down by double digits. Something to keep in mind…
Chris: This Is the Decade of Real Assets
Inflation is rising because there isn’t enough supply to meet demand. More black swans will put additional pressure on global supply chains. This will keep prices elevated.
The clear investment winner in this new age of inflation are commodities. We saw a bubble in digital assets of all kinds, from stocks to NFTs over the last two years especially. These investments aren’t “real.” Metals are. Grains are. Oil and natural gas are.
The Invesco DB Commodity Index Tracking Fund is beginning to reclaim its uptrend after the sell-off in June. It is up 40% over the last year.
DBC tracks a spread of 14 different commodities. It’s trading for under $27 now. I like call options dated out to April, or even January 2024, at the $30 strike and above.
This is the decade of real assets. If you’re going to buy and hold anything, it should be them. But there are better ways to make money right now. Strategies that allow you to rotate and play “follow the leader” are your best bet.
Adam O’Dell has been running one strategy that does this effectively for the last decade. His track record is amazing (I worked with him back in 2015, and I remember it’s all anyone was able to talk about).
Make sure you check out his new video coming out. It will teach you a lot about how to trade right now.
So we have a devastating European winter and Mad Max-worthy crime scenes to prepare for…
And, thanks to our experts, plenty of trade ideas to stay one step ahead of the market — including a fund that puts the beloved 60/40 portfolio to shame.
Thank you, as always, for being a loyal reader of True Options Masters. We couldn’t do this without you. Enjoy the rest of your Sunday, and we’ll be back tomorrow at 11 a.m. sharp!
Managing Editor, True Options Masters