by Dan May 22, 2011 11:16 pm • Commentary
Readers of this space know that I have a hefty dose of skepticism as it relates to this market, and have become increasingly convinced that the market is going to correct 10% over the next few months.  Being bearish most of the time can leave me feeling a bit lonely, and even though I know I am a Patriot all this negativity about our economy’s prospects leaves me feeling like a Pinhead sometimes…….Well enough fear and loathing, I am convinced the markets are massively underpricing a whole host of risks, especially with the market within a few % of multi-year highs made a few weeks back…..Look to protect stocks that you own, don’t over pay for that protection and if you can, try not to just sell etfs against your portfolio….
Lots of traders that I know have become less long/short, and primarily just long single names and short etf’s. The etfs help to lessen the blow in challenging markets, but most traders do not take into account correlations and properly adjust for betas of their longs.   For a lot of reasons (and through experience) I think this is a generally useless endeavor in an attempt to add “alpha” and will attempt to explain an alternative below that costs very little, but does take some concentration and trade management.
***Quick note, this was written last night before markets around the world took a bit of a bath….S&P futures currently down ~1%…..Trade example listed below should be used for educational purposes as the strikes and the actual strategy may not be appropriate for your portfolio and the prices used will most certainly be different this morning. The example is to be used against a portfolio of long stocks not as an outright bearish bet.

But first some quick technical points of reference:
-Since the QE2 trial balloon was floated late August 2010 the SPX is up ~28% (~1050 to ~1330)
-Since the March 16th Japan earthquake/tsunami lows (~1250) the market is up almost 7%.
-On pure technicals, if the market is going to correct at some point this summer, it will most certainly go through 1300 on is way to testing the previous “panic” intra-day low of 1250 and the closing low of 1257 in March, which sits about 1% above the 200 day moving average at 1238.
[caption id="attachment_2102" align="aligncenter" width="359" caption="1 Yr "][/caption]

A couple quick points about S&P vol:
-With the
VIX at ~17.40 (not far from the 2 year low made a few weeks back) most think that S&P vol is fairly cheap and to the unfocused eye it may be…..but if you look at the term structure of the SPX it doesn’t appear that way at all (17.4 in the vix is equivalent to an average daily move of about 1%). The term structure for at the money SPX options is fairly steep with June implied vol at about 14, July at 15 and August at 16, which appears expensive when you consider that the SPX has a 30 day realized vol of 10.66, and 60 and 90 day realized vol of about 12.50. This merely tells me that options traders think that the SPX will be more volatile over the next 3 months than it has been over the last 3 months, which is generally how SPX term structure looks (expensive to realized).   And more clearly, even with the VIX at ~17.5 fear IS being priced into the market.


-Let’s look at August options (expy 20th of Aug) in the SPY, as Aug should capture the bulk of S&P earnings.  I think 2nd half outlook holds the key to the markets near term success, and I believe some market participants may start to get wary of the end of QE and take some profits in anticipation of 2H guidance that could signal a slowdown in S&P earnings……
-With the SPX up 6% ytd I think it is very possible that we see at-least a 7-10% draw-down from the multi-year highs made 3 weeks ago, which would put us right near the 200 day moving average and below the 1250 support level and heading towards the MASSIVE 1200 support/resistance level (see below) that goes all the way back to 2001. 1200 is the level that we broke just prior to 9/11, key resistance that we got through back in late 2004 to later match the bubble highs of 2000 and then only to stop briefly back in 2008 before busting through post Lehman and falling another 45%!
-Last years break above this level on volume and it’s ability to make a series of higher highs and higher lows is very impressive to most technicians, and is one of the key reasons why most feel that any pullback is just a pause in a greater bull market… I prefer to take the other side and say that the almost 100% rally we have seen off of the Mar 2009 lows is largely the result of world governments’ efforts to create the most obscene and shallow asset bubble  of our lifetime.
[caption id="attachment_2103" align="aligncenter" width="392" caption="11 Yr SPX Chart   Provided By Bloomberg"][/caption]



Break-Evens on August Expiration:
-stock btwn 132 and 124 make up to 8.00 and
-below 124 (down 7.2%) make full 8.00 but have no further protection.
Upside: stock btwn 132 and 137 have no loss,  stock above 137 (up ~3%) and you are short, But your longs are presumably outperforming the index on the upside.

TRADE RATIONALE: Important to note the skew btwn the 5% out of the money Call (for the Aug 140 call is $1.10 in premium/13.5 IV) and the 5% out of the money Put (for the Aug 127 Put is $2.50 in premium/19.50 IV), options market clearly placing a higher emphasis on downside puts than upside calls.   One of the benefits of this structure is that if the stock goes sideways there is a very decent chance  you will actually make money at some point on this trade, as you are net short options, and you are actually short one of the most expensive options in the chain (the Aug 124 Put).
-But the only real risk other than not having protection below $124 in the SPY,  is the risk of getting short the SPY up 3% at 137 on August expiration…..I chose the 137 strike because that is the previous high from 3 weeks ago.  I much prefer this sort of structure to selling cash etfs against longs as it gives your longs room to breath but gets you get near the money protection on the major index without paying a lot for it.
***This trade example is for educational purposes and the strikes that I have chosen or the appropriateness of the strategy need to be vetted by the reader and/or their financial advisor.