For months, market observers have been hearing just how well trade negotiations have been progressing between the United States and China.
Images of smiling diplomats walking around airport tarmacs and hotels in Washington DC and Beijing had catalyzed countless headlines suggesting that "trade war optimism" was oozing through the capitals of the United States and China.
Correctly or not, the melt-up in international equity prices observed since the start of 2019 was widely attributed to these "productive talks." At points in April, it seemed that the only impediment to the signing of a wide-ranging trade deal between the two largest economies in the world was finding a convenient day and time for the ceremony.
Then came a fresh barrage of tweets from President Trump.
Apparently negotiations weren't going quite as well as many had come to believe.
Instead, President Trump indicated that the gap still remained too wide between the two countries interests. Moreover, US negotiators were finding that previously agreed upon points of contention weren't as "final" as they were led to believe - especially when it came to recording them in an official agreement, with accompanying enforcement mechanisms.
It has now been roughly 5 months since the United States and China first agreed to a "truce.” And as of Friday May 10th, it's expected that truce will abruptly end.
Noting a lack of material progress in trade negotiations, the office of the United States Trade Representative filed public notice recently saying that tariffs on $200 billion in Chinese imports will increase from 10% to 25% as of the 10th of May 2019. Likewise, President Trump has foreshadowed that new tariffs may soon be applied to another $325 billion of Chinese imports.
Barring a last minute agreement, negotiated in the shadow of these new tariffs, it appears the recent truce between the United States and China will become a part of “trade war” history.
The question of course is what comes next.
China already announced that $60 billion in US exports to China will be hit with new tariffs. But is that the end of the “tit for tat” game? Recent history suggests no.
China holds the most US sovereign debt of any foreign entity (over a trillion dollars worth), which you’d think would provide the Chinese with a decent amount of bargaining power.
Likewise, China could threaten to pivot closer to adversaries of the United States, such as North Korea, Iran, and Russia. The relationship between China and North Korea has arguably already proven to be an obstacle in negotiations with Kim Jong-un. It's also been rumored that in response to the new tariffs, China plans to defy the US-organized boycott of Iranian oil exports.
And if the United States is playing hard ball, who could blame the Chinese for adopting a similar stance? Maybe President Xi Jinping read Trump: The Art of the Deal and feels he can outmaneuver President Trump using his own methodology?
Whatever the case may be, and whatever the outcome, there's only one certainty going forward - nobody knows exactly how the trade war will play out.
But for traders of volatility, there are several metrics that never lie. One is the VIX, which spiked to a three-month high on the first day of trading after news of the stalled talks was released.
For many tastytraders, the second is Implied Volatility Rank (aka IV Rank or IVR), which reports how high current implied volatility is trading relative to the last 52-weeks of data. It’s certain that IV Rank will be rising across the implied volatility universe along with the VIX.
The fact is, it's nearly impossible to track every market narrative flowing through the financial markets. And if we could track all of them, it would be equally impossible to accurately assign a degree to which each one matters.
Instead, volatility traders attempt to prey upon fear and complacency in the market. When investors are fearful, options prices tend to rise - along with the VIX and IV Rank. And when complacency takes over, the opposite tends to occur.
Because we can observe the mean-reverting nature of volatility, we can also attempt to profit from this behavior.
For premium sellers, the recent uptick in volatility isn't about identifying the flavor of this month's narrative, it's about incrementally deploying slightly more capital toward short premium exposures - assuming that course of action matches your outlook, strategic approach, and risk profile.
The VIX is higher, and sometimes that is all one really needs to know. This is especially pertinent because of the recent pattern observed in VIX which suggests it tends to "pop aggressively" before reverting and clustering.
For more information on the "cluster, pop, revert" pattern observed recently, we recommend reviewing this previous installment of Market Measures. And for more information on the recent spike in volatility related to the “trade war,” we recommend this new installment of Options Jive.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.