US equities experienced a sharp decline on Tuesday due to rising geopolitical risks after President Donald Trump intensified rhetoric about acquiring Greenland and threatened new tariffs against US allies. This led to a reduction in exposure to US assets, with the Dow Jones Industrial Average dropping 1.4%, and the S&P 500 and Nasdaq Composite falling 1.6% and 1.8%, respectively.
The VIX index climbed above 20, indicating mounting uncertainty. Trump plans to impose tariffs starting at 10% on imports from eight NATO countries, increasing to 25% by June, and threatened 200% tariffs on French wine. European leaders are considering retaliatory measures, which could escalate tensions further. The market’s pricing for optimistic outcomes has made it vulnerable to policy shocks.
The Euro Strengthens
The Euro strengthened against the US Dollar as bonds sold off sharply. Technology stocks remained weak, with Apple and Meta declining approximately 8% year to date, while Microsoft dropped about 6%. Conversely, defensive stocks like Walmart and Procter & Gamble reached new highs, offering some stability. Small caps showed resilience, with the Russell 2000 outperforming the S&P 500 for the twelfth consecutive session.
On the policy side, Treasury Secretary Scott Bessent indicated that Trump might soon nominate the next Federal Reserve chair, with a decision expected shortly. This development is a key factor for markets to consider.
With the VIX climbing above 20, a level not seen since last November, we should consider buying protection against further downside. This could involve purchasing put options on broad market indices like the SPDR S&P 500 ETF (SPY). Looking back at the volatility during the 2018-2019 trade disputes, the VIX often sustained levels above 20, suggesting this spike may just be the beginning if tensions escalate.
The clear divergence between sectors points to specific strategies. We can express a bearish view on large-cap technology through put options or bear call spreads on the Invesco QQQ Trust (QQQ), as high-valuation stocks are particularly vulnerable to policy shocks. At the same time, the strength in defensive names like Walmart and Procter & Gamble suggests selling cash-secured puts on these stocks could be a way to collect premium amid the turmoil.
Small Cap Outperformance
The outperformance of small caps is the most compelling trend to follow. We should consider pairs trades, such as going long call options on the iShares Russell 2000 ETF (IWM) while simultaneously buying put options on the Nasdaq-tracking QQQ. This strategy isolates the outperformance of domestically-focused companies, as recent data shows Russell 2000 firms derive nearly 80% of their revenue from within the US, compared to just 60% for the S&P 500.
The US Dollar’s sharp drop is another area to watch, as sustained tariff threats could erode foreign demand for US assets. We can look at buying call options on currency-hedged ETFs, such as those tracking European equities, to gain from a potentially weaker dollar. The upcoming meetings in Davos will be a critical indicator of whether this currency weakness will persist.
Upcoming events like the Davos meetings and the Federal Reserve chair nomination are guaranteed to introduce more volatility. We could use options straddles or strangles on major indices to profit from large price swings in either direction, without having to predict the outcome of these high-stakes events. This is a prudent way to position for the known uncertainty of the next few weeks.
