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Morgan Stanley explains why the end of wild swings in the stock market is near — and shares the perfect trade to profit from the calm ahead

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  • The coronavirus crisis recently sent a gauge of stock-market volatility spiking to a level last seen during the 2008 credit crunch. 
  • This elevated state of market activity is now poised to give way to more muted gains, according to Andrew Sheets, the chief cross-asset strategist at Morgan Stanley. 
  • He shared an options-trading strategy for enhancing returns even as the market rises at a slower pace. 
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Investors are by now accustomed to massive daily swings in markets that became the norm as the coronavirus outbreak escalated. 
But before you get too familiar with extreme fluctuations, Morgan Stanley strategists are out with a reminder that this environment is not normal. They even take it a step further to argue that a return to some form of normal is coming over the next quarter.
Like many other financial metrics in 2020, implied volatility for the S&P 500 surged to levels that were matched only by previous crisis moments. In the thick of the sell-off last month, it spiked to its 2008 peak above 60. It has since fallen nearly 30 points from its peak, but remains in the 95th percentile of its 15-year history, as the chart below shows.
Screen Shot 2020 04 23 at 11.54.54 AM
Implied volatility would have fallen even more sharply but remained elevated because of the unusual speed of the stock market's recovery from its March bottom.
There are now at least three reasons why volatility should calm down from here on, said Andrew Sheets, the chief cross-asset strategist for Morgan Stanley, in a recent note.
First, central banks have rushed to flood markets with liquidity and support companies that need access to credit. So far, investors have not fought the Fed by restoring more than half of the stock market's losses.
Secondly, Sheets said a peak in new cases will likely come within the next two months. That development would begin to flatten the all-important curve and help more engines of the economy get restarted.
On a related note, his third point is that the trough in economic activity would accompany the peak in new infections.
"Even if the trajectory of recovery is still uncertain, broad contours of the trading ranges are now established," Sheets said.
That range is unlikely — for a second time this year — to send volatility shooting beyond its most elevated level since the credit crisis, he added.
"With lower volatility, we expect rallies to be more measured and gradual," Sheets said.
His trading recommendation for more muted rallies is to enhance income by overwriting S&P 500 call options.
This strategy involves selling options — bets on a rally in this case — that are believed to be overpriced, and it is most lucrative when the underlying security does not exceed the call's strike price. In other words, the trade is a bet that investors' expectations for future volatility will not be fully realized.
Morgan Stanley's equity strategists estimate that the S&P 500 will end the year at 2,500 in a bearish scenario and 3,250 in a bullish scenario.
Based on this range, Sheets shared the following recommendation: Sell one-year 110 strike calls on the S&P 500 (yield 5.9%, breakeven ~3250). The risk to this trade is that the S&P 500 zooms past 3,250 and returns to its all-time high of 3,386.15.
"We look here at economics of selling a call 10% above the market through the end of this year," he added. "In equities, we get to yields of 5-6%, with breakevens levels for S&P 500 close to the highs of the year and above our bull case forecast. In a low rate environment, high single-digit yields will prove attractive to investors, in our view."
SEE ALSO: Wall Street's best-performing fund this year breaks down its long-term strategy that's outsmarting 99% of its peers — and shares 7 stocks to buy for a post-pandemic world
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