A War With Iran Would Make Markets Crazy. This Stock Would Benefit.

Mourners carry the coffin of slain Iraqi paramilitary chief Abu Mahdi al-Muhandis, toward the Imam Ali Shrine, in the shrine city of Najaf in central Iraq during a funeral procession on January 4, 2020. Photograph by Haidar Hamdani/AFP via Getty Images

If President Donald Trump unleashes the full might of the U.S. military against Iran, the Cboe Volatility Index would almost certainly surge, and the VIX’s owner, Cboe Global Markets, would profit.

An outright war, a major attack, or any sharp escalation of what has been mainly an exchange of threats following the drone attack that killed a top Iranian general, would likely prompt investors all over the world to panic and rush to buy VIX calls to hedge or trade the conflict. The increased trading volumes would benefit Cboe (ticker: CBOE), which exclusively lists and trades VIX options and futures.

When stock prices decline, the VIX tends to increase. The relationship is so well known that investors who are worried about declines, or want to short stocks, often buy VIX calls to profit from rising volatility.

We have mentioned in the past month that investors were starting to place defensive trades, centered around January, given the potential for tumult from the presidential campaign. The trades also provide protection from Iran-related market swings, but the possibility of war with Iran was never part of the mainstream narrative.

Now, war is a market factor and investors must decide if they want to ignore the risk, or try to get ahead of it. The latter is likely better—especially because you can do so with little expense.

Consider Cboe as a stock proxy for the current geopolitical and market risk. The company is well positioned to profit from war. Aside from VIX, the exchange also exclusively lists options on the S&P 500 Index. The two financial products are key tools that institutional investors use to manage portfolio risks.

So, if Iran attacks America, as it has threatened, investors would likely buy VIX calls and index puts to protect portfolios and trade the war. Cboe should see an increase in trading volumes, which would increase revenue, and the stock should respond favorably.

We realize that all of this sounds cold, given that it involves the loss of human life, but the potential moves are simply the reality of markets.

If the war theme seems attractive, investors can buy Cboe’s March $125 call for $2.40 and sell the March $115 put for $2.55, assuming the stock is around $120.

This risk reversal—that is, selling a put and buying a call with the same expiration but different strike prices—essentially pays investors for agreeing to buy Cboe stock at $115, while profiting from rallies above $125. If the stock was at $130 at expiration, the calls would be worth $5.

The key risk is if the stock sinks far below the put strike price, but that seems unlikely for as long as investors are concerned about war and what happens to the stock market.

Email: editors@barrons.com

Powered by WPeMatico