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S&P 500 Index Volatility Trade

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This is an important week, and traders should be bracing for some volatility as the economic calendar, central bank meetings, and asset flows could arrest the rally in stocks.

- The U.S. economic calendar alone is heavy enough to warrant some caution. Monday has the Dallas Fed survey, and on Wednesday morning we get the first Q2 GDP number and Chicago PMI. The FOMC announcement is on Wednesday afternoon, and investors will obviously be watching for a change in the Fed's communications policy. PMI Manufacturing and ISM Indexes are released on Thursday, and Friday is NFP day. Those are just the highlights, of course.

- The ECB and the Bank of England are also holding meetings this week. Both banks are expected to maintain their current dovish stances.

- Goldman's David Kostin notes that, excluding financial stocks, second quarter earnings haven't been that great, with year over year per-share earnings falling 1%. Clients appear to be focused more on policy questions and on the rotation from bonds to stocks than on the fortunes of particular companies. Perhaps that means less scrutiny and more leeway for underperforming industries? It also means a poorly received Fed message could trigger indiscriminate selling.

- Japan is falling as the Abe government makes some clumsy moves to reconsider its sales tax hike, and this after data showed more bad inflation (rising energy costs) and poor retail sales data (no wage growth). Abe and Kuroda are not going to roll over and let the last year's worth of progress get reversed by some poorly-timed communications, but in the short term a cooling of the hot money flows out of Japan is worth watching.

Given those caution flags, investors should consider owning a strangle on the S&P 500 Index (SPX) to protect against an increase in volatility in the short term. SPX options don't appear cheap at first glance, with one month trailing volatility of just 7.1% comparing poorly with the 11% implied volatility reflected in at the money options expiring at the end of August. However, SPX realized volatility was at 16% as recently as mid-July, and it would only take a few tumultuous sessions to see that statistic jump again. On that basis, short term options look priced pretty favorably for hedgers, and the following options strangle will offer some protection against swings in the near term:

Trades: Buy to open SPX 1660 Aug30 (W) puts for $14.70 and buy to open SPX Aug30 (W) 1720 calls for $9.40.

With a month remaining until these options expire, the time decay this week should not be too great, and we will plan on exiting the position on Friday.

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At the time of publication, Jared Woodard held positions in SPX.

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