The past week brought on a liquidity-infused rally, started by dovish remarks by the Federal Reserve and amplified by the European Central Bank (ECB) committing to the stability of the Euro zone through bond purchases.
This has led to a multi-year breakout in equity indexes, coupled with large moves in precious metals and a pullback in the dollar. By several statistical measures, the “risk-on” play is becoming overbought, but what is the best way to play it?
The Volatility Index or VIX, which measures the demand for S&P options, is coming in at the low 15’s. This may seem cheap but relative to the actual volatility in the SPX the premium may be too rich.
Instead, consider the euro/dollar (EUR/USD). It is running up into resistance from May levels as well as a declining moving average. If the risk-on play suddenly goes risk-off, this will be one of the assets to revert.
On top of that, euro options are fairly cheap. Euro FX Volatility (EVZ), which measures the demand for FXE options (a euro ETP), is now in the low 9’s, a statistically significant reading– and relative to the actual volatility in the euro, there is little premium available. See Figure 1 below.
Downside players may consider purchasing the Dec 126 put for around 2.15. This would give the trader a reasonable hedge against any adverse movement in the euro, which in turn would protect against long equity positions. See Figure 2 below.
The rally in equities may persist, but those looking for reversion would be better suited looking at other proxies such as euro options.