Name That Trade – SPY: It’s a 1-8-7 for Another Market Drop

by Dan May 16, 2014 3:13 pm • Commentary

If U.S. equity investors were handing out a scorecard for ytd performance, on a relative basis, the S&P 500 would have to receive a B+, up 1% on the year, only down 1.7% from the all time highs made last week.  The Nasdaq and the Russell 2000 on the other hand are likely to need a little extra help at this stage of the school year with the Nasdaq down 7% from the multi-year highs in March, down almost 3% on the year, and the Russell down 10% from its all time highs in March, and down 6% on the year.

The S&P 500 is for all intents and purposes the last man standing among U.S. equities.  The index has in some ways become a safe haven trade as investors assess the risks of their holdings, shunning smaller issues and higher valuation stocks.  To get a better sense for the bullish complacency towards the large cap index, look below at the SPX vs the VIX over the last 5 years:

SPX bs VIX 5 yr chart from Bloomberg
SPX bs VIX 5 yr chart from Bloomberg

The one year chart of the SPX shows the index sitting right on key near term support of its 50 day moving average (purple), with the next target of 1815, the low from April, and then the 200 day moving average at 1786, a momentum measure the index has not touched since November 2012.

SPX 1yr chart from Bloomberg
SPX 1yr chart from Bloomberg

On Tuesday, following the SPX’s most recent record close, I highlighted the following data of the SPX / Russell relationship over the last 14 years, from Michael Batnick, who writes The Irrelevant Investor blog:

The Russell 2000’s current 10% peak-to-trough decline (its first since November 2012) is small caps’ 36th peak-to-trough decline of at least 10% since 2000, with an average decline of 17.1%. Of the first thirty-five corrections, every one of them were accompanied by large-caps also falling, until now (an average decline of 12.8%).  

So, if history is any sort of guide, the SPX’s most favored nation status could be in serious jeopardy if the Russell can’t find its footing soon.  I don’t know about you, but this is a pretty nasty looking chart that appears to be on the precipice:

Russell 200 1yr chart from Bloomberg
Russell 200 1yr chart from Bloomberg

As stated above, SPY vol, the price of options, is cheap as chips, implying fewer than 1% intra-day moves at about 11:

SPY 2 year chart of 30 day at the money IV from Bloomberg
SPY 2 year chart of 30 day at the money IV from Bloomberg

For those who think the weakness in small cap and high valuation stocks continues, and that sooner or later investors will turn their sights on the SPY, directional bets are very attractive with outright options purchases. WE ARE NOT PLACING THIS TRADE AT THE MOMENT, AS THE THE INDEX JUST HELD THE 50 DAY MOVING AVERAGE THAT MOST TRADERS ARE KEYING ON.  But we  are going to wait, and look to put this trade on if the SPX gets rejected at the previous highs.  BUT we wanted to lay this out for those directional players, or for those looking for portfolio protection:

HYPOTHETICAL TRADE:  Buy to open the SPY ($188) June 187 Put for 2.50

Break-even on June expiration:

Profits: below $184.50

Losses: of up to 2.50 between $184.50 and $187, with max loss of 2.50  at $187 or above.

Rationale – This is both a dollar cheap and low implied volatility bet that the SPY is unable to hold this support level so close to recent highs. The put risks about 1.5% of the SPY to play for that potential breakdown. We’d likely spread the put on a break below support.