Name That Trade – $SPY: Considering Portfolio Protection

by Dan March 27, 2015 2:27 pm • Commentary

Earlier today we entered in a new trade in the IWM (read here) based on a few factors, most notably the pattern of increased downward volatility in the first few weeks of a new quarter over the last year, and also the very recent weakness in the biotech sector off of all time highs. Its our view that the Russell 2000 will likely be at the forefront of any sell off that is valuation focused. We already have a QQQ trade on in May (read here) for slightly different reasons, but wanted to highlight what we think could be suitable portfolio protection for those who have more large cap equity exposure.

Looking at the S&P500 chart there is little that flashes alarm just yet, as the index has seemingly been basing between 2000 and 2100 of the better part of the this year, despite being flat in 2015:

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

As one would expect, options prices in the SPY are among the cheapest in vol terms from the major U.S. equity indices, and implying less than 1% intra-day gains:

SPY 1yr chart of 30 day at the money Implied Vol from Bloomberg
SPY 1yr chart of 30 day at the money Implied Vol from Bloomberg

I would add one thing, 10 day realized volatility in the SPY just bounced off of the lows since the bull market started in 2009, which could signal that large cap U.S. equity vol hit an inflection point, and could be ready to play a little catch up to the movement we have see in commodities, currencies and bonds over the last six months:

SPY 10 day realized vol from Bloomberg
SPY 10 day realized vol from Bloomberg

It has been my view for weeks now that momentum has been waning, prior leaders like consumer staples, utilities and large cap tech (ex Apple of course) show a failure of prior leadership, and potentially declining breadth.  Which is why in the IWM post from earlier I highlighted the recent downward volatility in Biotechs, which have been massive market leaders:

a look at the valuations the four largest components of the $IBB – AMGN, BIIB, GILD and CELG (which make up about a third of the weight of the etf) – are not exactly expensive when you consider their expected growth. But its safe to say that my not be the case further down the market cap food-chain, like in the XBI (the S&P Biotech etf) which is far more evenly weighted among a much broader group of smaller market cap stocks which is far less palatable from a valuation perspective. The XBI displayed far greater volatility in the last week than did its larger cap brethren, the IBB. At one point in the last week the XBI was down 15% from the recent all time high made on March 20th, and is still down 10% (vs now 7% decline and at its worst 10% decline in IBB).

Add in the start of Q1 earnings season in a couple weeks, no shortage of geopolitical events heating up and the uncertainty about when the Fed will raise rates, with the S&P500 only 3% from the all time highs looks like something worth slapping some protection on.  As for the Fed, the next meeting is scheduled for June 17th, which makes June expiration attractive.

Potential Protection: SPY ($205.55) Buy June 200 / 180 Put Spread for $3

-Buy 1 June 200 put for 4.35

-Sell 1 June 182 put at 1.35

Break-Even on June expiration:

Profits: between 197 and 182 make up to 15, max gain of $15 at 182 or lower.

Losses: between 197 and 200 lose up to 3, max loss of 3 above 200, or 1.5% of the SPY

Rationale: If you are considering cutting your large cap equity exposure as you worry uncertainty around the Fed’s timing on rate increases could cause volatility, in addition to the other reasons I stated above, then risking 1.5% to possibly mitigate 7.5% of losses down to the October lows could make sense.