A low-cost way to protect against an S&P 500 drawdown as risks escalate

Published Mon, Oct 16 202310:24 AM EDT

Here's how options traders assess rising market risks and hedge their portfolio. The Cboe Volatility Index , commonly referred to simply as "the VIX", is an index derived from 30-day S & P 500 index options prices. Put simply, the VIX represents the options market's expectations for S & P 500 volatility over the next 30 days. Sometimes referred to as a "fear index", Friday's VIX Index closing level of 19.32 is only slightly below the 6-month high of 20.09 seen on May 4th. The VIX has three primary drivers right now: Economic - Investors are closely scrutinizing inflation data, Federal Reserve comments, employment data and sentiment indicators to handicap rate policy and the pace of economic growth. Both producer prices and consumer prices data came in a bit hotter than the expectations last week. Higher-than-expected inflation data is seen as a negative for stocks and will elevate implied volatility because investors assume the Fed will maintain a more hawkish/restrictive posture, keeping rates high(er) for longer. University of Michigan Sentiment also came in lower than expected. Geopolitical - While U.S. equity markets had essentially priced in risks associated with the war in Ukraine, a conflagration of the scale seen this past week in the Middle East was not. Skirmishes and Hamas rocket attacks are routine enough that they had been priced into risk-premia for U.S. equities, but a terrorist attack of the scale and brutality last week was not. Beyond the military response to Hamas primarily in Gaza, but also in the West Bank by IDF, these events paused efforts to normalize relations between Israel and Saudi Arabia, and potentially escalated Israel's conflict with Hezbollah in Lebanon, another Iran supported terrorist group. This is significant because U.S. actions, sending at least one carrier group to the region (Gerald Ford), and the movements of a second (Dwight Eisenhower, aka "Ike") emphasize the magnitude of the risk. Add Iran's threats of a wider war by an "Axis Of Resistance" and the risk of multiple proxy wars in Europe and the Middle East at the same time have risen sharply. How risky is this situation? Famed hedge-fund manager Ray Dalio, founder of Bridgewater Associates, suggested these events threaten to spark a World War . Earnings - It's well understood that stock prices tend to move more sharply as new information comes to light, and the pace of quarterly earnings releases tends to ebb and flow. Many companies within a sector or industry tend to report quarterly earnings around the same time, and among the earliest to report within each earnings "season" are the big banks which kicked off on Friday with JPMorgan , Wells Fargo , Citigroup whose results were generally well received. Financials significantly outperformed, finishing Friday up 0.2% while the S & P overall fell by 0.5%. All else equal, if stocks become more volatile, so will the indices that contain them, so we might expect to see the VIX index rise as we enter the meat of the earnings season. However the impact of the heightened volatility in single-stocks around earnings impacts the index less than the "macro" economic and geopolitical risks I mentioned above. The reason is that macro risks often impact many, if not all stocks, while earnings are more idiosyncratic, stock and industry specific and offset somewhat in a well diversified portfolio. .VIX 6M mountain VIX, 6 months While we should identify those individual earnings likely to move stocks sharply (which one can see in the table below), today it feels appropriate for us to focus on macro risks first. Options traders and strategists are often asked, "Is there a way to use options to hedge my portfolio?". In a word, yes. Hedging market risk using a put spread One way to hedge one's portfolio against the heightened risk, is the use of a long (debit) put spread using options or an ETF that represents a suitable proxy for one's portfolio. Let's use the SPDR S & P 500 Trust (SPY) as an example: Trader buys the SPY January 430 put, pay $12.50 Sells the SPY January 400 put at $5.65 Total cost $6.85 x 100 (each contract represents 100 shares) = $685 premium outlay for trader SPY 6M mountain SPDR S & P 500 ETF Trust (SPY) The per share cost of the trade of $6.85 is 1.6% of Friday's $431.50 SPY closing price. The put spread will be profitable (at expiration) if SPY falls below the 430 strike put that one would buy in this structure by at least the $6.85 spent, or $423.15, (or less than 2% lower). The max profit of the hedge is $23.15, or nearly 5.4% of the current price of SPY if SPY drops to the lower 400 strike or lower as/of expiration on January 19th, 2024. The way to think about how to size one's position is to first establish the size of the equity portfolio involved. For example a $250,000 equity portfolio is equivalent to 580 shares of SPY ($250,000 / $431.50/share rice of SPY = 580 shares). Since each SPY options contract represents 100 shares one could round up to 6 contracts, representing 600 shares and a total premium outlay of $4,110 using these prices, or down to 5, representing 500 shares of SPY and an outlay of $3,425. A put spread of this type isn't a "perfect" hedge. While it does represent a relatively inexpensive way to mute the downside risk to one's equity portfolio if the S & P 500 should falls by 5-7% over the next few months, the insurance it provides is more limited than purchasing puts outright. In the event one is concerned about a far sharper decline and is really looking for catastrophe insurance, simply purchasing a January SPY put outright as a hedge may be a simpler solution such as the SPY January $420 puts, which cost $9.60 as of Friday's close. The compromise one makes in this strategy is that the cost in this example is 40% higher than the put spread described above. Additionally the protection, as/of January expiration, doesn't kick in until $420-$9.60 = $410.40. Using an insurance analogy, the outright put has a higher premium AND a higher deductible (SPY would need to decline almost 5% before the hedge would be profitable), but the benefit is that the downside protection beyond that decline is more comprehensive. Bottom line: The put spread costs less, has a higher probability of profit and offers limited protection. The outright put is simpler, and offers more profit potential in the event the market declines very sharply (i.e. more than 10%), but costs more, has a lower probability of profit, and less near-downside protection. Earnings ahead The table above identifies several of the companies that will be reporting earnings this coming week where options markets imply the could move more than twice as much as the S & P 500. Which is even more notable when one considers that (Note names highlighted in green are stocks we own/hold in our equity long-only event-driven ETF). THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL'S UNIQUE PERSONAL CIRCUMSTANCES. 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