As part of some new offerings we’ll be concentrating on potential portfolio hedges when we feel the market could be at inflection points. In August we showed a couple potential hedges using SPY options before a brief selloff and bit of volatility. We’ve also featured a number of VIX trades recently (like this one) that also act well as portfolio hedges. These hedges will be posted on their own page (Portfolio Hedges) that can be accessed from the Trades dropdown on the menu bar.
With the S&P 500 at all-time highs, and up almost 7% in less than 3 weeks, we thought it prudent to take a look at some portfolio protection strategies that protect profits into the end of 2013, while allowing for further upside in case of a year-end melt-up.
The timing seems appropriate today given the weakness in the past week of a number of former market leaders, like TSLA, NFLX, solar stocks, and Chinese internet. We also have the crucial FOMC release tomorrow, which could be a non-event, but also could be an excuse for some portfolio managers to take profits. Moreover, as we noted in the Macro Wrap yesterday, small caps vs. large caps is at an important inflection point.
In this light, here are 2 structures that serve slightly different purposes, but that both offer reasonable risk/reward as portfolio protection heading into Wednesday’s FOMC release and the last 2 months of 2013:
Note: both are structures where you have to pay premium. Since implied volatility is so low, net credit structures (where you collect premium) did not offer attractive risk/reward.
First Potential Hedge – Paying for Full Protection into year end:
SPY ($176.45) Buy the Dec31st 173 put for 2.50
- Buy 1 Dec31st 173 Put for 2.50
Break-Even on Dec31st Quarterly expiration:
Caveat: This is only a trade that you should do if you are willing to lose the full 2.50 in premium, presumably because you have nice portfolio gains in 2013, and are willing to risk some long option premium for the benefit of portfolio protection into year end.
Where You Get Protection: If SPY closed above 173 on Dec31st expiration, you will have given up an incremental 2.50 of premium, or about 1.5% of current SPY spot. However, if you are willing to risk losing that amount, then this structure offers full protection below 170.50, which is essentially protecting the SPY at a level that is still up almost 20% in 2013.
Trade Rationale: This structure (an outright put purchase) is rare for us on the site, and it’s not one that we would normally do in a speculative capacity. However, with implied vol in the S&P 500 still near 5 year lows, and the S&P 500 index at all-time highs, simply buying an outright put offers better risk/reward protection characteristics than most usual protection structures that we’ve laid out in the past.
The SPY index has traded above 170.40, the break-even level for the put purchase, on less than 20 trading days in 2013:[caption id="attachment_31807" align="alignnone" width="600"] SPY daily, Courtesy of Bloomberg[/caption]
Second Potential Hedge – Paying for Partial Protection into year end:
SPY ($176.45) Buy the Dec31st 172/162 Put Spread for 1.54
- Buy 1 Dec31st 172 Put for 2.22
- Sell 1 Dec31st 162 Put at 0.68
Break-Even on Dec31st Quarterly expiration:
Caveat: This is only a trade that you should do if you are willing to lose the full 1.54 in premium, presumably because you have nice portfolio gains in 2013, and are willing to risk some long option premium for the benefit of portfolio protection into year end.
Where You Get Protection: If SPY closed above 172 on Dec31st expiration, you will have given up an incremental 1.54 of premium, or about 0.9% of current SPY spot. However, if you are willing to risk losing that amount, then this structure offers protection from 170.46 down to 162, which is essentially protecting the SPY down to the 200 day moving average.
Trade Rationale: The put spread only offers partial protection compared to the outright put, but it only sets you back a bit less than 1% of current SPY spot, so it’s a cheaper premium outlay. The strikes are structured to give you protection near the August lows, which correspond to the 200 day moving average.
Trade Differences: The outright put purchase is more short deltas, so for those that are looking for protection on an immediate pullback that could be tradeable, this is the structure. For those looking for more of a set it and forget it hedge, the put spread is a nice structure because it’s less premium outright and has a very realistic protection profile.
Once again, these are not trades that we are doing, and would not do them on their own if there was not a long portfolio or position that you wanted to protect. These are trades where we would only risk what we were willing to lose, as the probability of an out-of-the-money put making money is still less than 50/50. But it’s cheap protection in a very strong market, and a worthwhile consideration for those looking to sleep easier into the end of the year.