As I write this during market hours on Friday, the S&P 500 is down another 4.5% and the Nasdaq is now in bear market territory, down 20% from its highs. Clearly, the tariff regime implemented has greatly exceeded the market’s expectations. In times like this, let me remind you of Warren Buffett’s mentor, Benjamin Graham. Graham developed the concept of the hyper-emotional Mr. Market. On every trading day he will buy or sell your stocks. On some days, he thinks stocks are going to the moon and will pay very rich prices. On others, he wants to sell everything, however undervalued the stocks might be.
I think one potential mistake people might be making is assuming that these levels of tariffs are likely to persist for a long time. The levels are so high and so disruptive, that they really demand negotiation. If some type of compromise could be reached with a few of the larger trading partners, leading to lower tariff levels, we could see a massive relief rally. A lot of businesses are simply uneconomical at the current tariff levels, so there are huge incentives and pressure on all sides to negotiate.
I’d like to take a moment to remind people about volatility and how it impacts options prices. Let’s say hypothetical stock ABC is trading at $75 per share. We like the stock but prefer the risk/reward that selling puts can give us. In this example, we are going to sell a $60 put expiring in January of 2025 for $6.00 per share, or $600 for the contract. Our target profit is $600 on a maximum risk of $5,400 (60×100=6,000-$600 premium=$5,400). This equates to a target return of 11.11%, which we like. Importantly, with the stock at $75 and our breakeven of $54, the stock could drop by 28% at expiration before we would lose a penny, and if exercised we would be happy to own the stock and have all the upside from there.
However, let’s say the market drops hard like it has recently, and stock ABC sells off to $60. That $60 put option might now be trading for $1,500, putting you at a short-term mark to market loss of $900. Ouch. But keep in mind that if the ABC stock closes at $60 at expiration in January, that $900 mark to market less evaporates and you retain your $600 profit, for a $1,500 reversal. Volatility spikes like we have seen these last two days will cause severe short-term mark to market losses, which become completely irrelevant upon expiration of the options, where the only thing that matters is where the stock is at relative to the options. Often our biggest winners come from being exercised on puts at really cheap levels and riding the stock higher again.