Trade tensions are calming down as the US has reached two important trade deals with Japan and the EU. Currently, discussions are happening in Sweden to extend the trade pause between the US and China, which ends on August 12. Negotiations started on Monday and may go on, increasing the chances of an extension. However, there is a small chance that no agreement will be reached. People are also focused on the Federal Open Market Committee, as a tougher statement could surprise the markets.

Indicators of Economic Health

No rate cuts are expected, but there is some worry about complacency. The US labor market shows little slack, and there are signs that core inflation is rising. The S&P 500 (SPX) looks strong, but it’s unclear if this strength is real or just a sign of complacency, as shown in daily candle patterns. With trade agreements in place with major partners like the European Union—which received over $336 billion in US goods last year—geopolitical concerns are decreasing. This situation could lead to lower implied volatility, making strategies that benefit from time decay, such as selling out-of-the-money options, appealing. We believe this calm environment provides opportunities to earn premiums. The market seems to be betting on a positive outcome for the extension talks with China. This sets up an uneven risk profile; if no agreement is reached, there could be a larger decline than the gains from a successful extension. Holding long positions without a hedge during this time carries significant risk.

The Need for Strategic Hedging

We are particularly worried about the complacency surrounding the Federal Open Market Committee. The latest Non-Farm Payrolls report showed a solid addition of 272,000 jobs in May, while core inflation remains high at 3.4%. This suggests the economy may be too strong for a gentle approach. There’s a risk that the chairman’s statement could be more aggressive in addressing inflation than the market expects. Given this potential for a hawkish surprise, we think buying protection is both smart and affordable. The CBOE Volatility Index, or VIX, has been hovering around a historically low level of 13, indicating that option premiums are cheap. Buying out-of-the-money puts on the S&P 500 or VIX call options offers a budget-friendly hedge against a market downturn. The strength seen in daily candles might hide underlying weakness. We’ve seen this before, such as during the market’s sharp decline in the fourth quarter of 2018 after a Fed meeting was viewed as too aggressive. A careful derivatives trader should be prepared for a potential pullback if the chairman’s press conference unnerves investors. Create your live VT Markets account and start trading now.

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