Name That Trade – $SPY: Reconsidering Portfolio Protection

by Dan August 12, 2015 2:23 pm • Commentary

By now you know the score. Small cap stocks in the form of the Russell 2000 (IWM), despite still being up on the year, have of late shown relative weakness to large caps, down 7.5% from its all time highs made in late June:

IWM 1yr chart from Bloomberg
IWM 1yr chart from Bloomberg

 

Oh and we recently have seen that creepy death cross (50 day moving average crossing below the 200 dayin the Dow Jones Industrial Average, with that index down 5.5% from its all time highs:

INDU 1yr chart from Bloomberg
INDU 1yr chart from Bloomberg

And the S&P 500 (SPX), despite breaking below its 200 day moving average, holding at key support today at 2050:

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

What’s clear about the first two charts is that momentum in small caps, and a small group of large U.S. multinationals have been waning for a couple months. The SPX tells a slightly different story as it, for now, remains in the very tight trading range it has been in for the last seven months.  The lack of movement in the index, despite some massive moves in large components like AAPL, DIS, GOOGL & XOM has caused only a mild uptick in both realized (how much the index has been moving) and implied volatility (option prices) on the index.  The one year chart of both for the SPY shows the recent uptick in both, but well below recent highs into the Greek debt deal, and down nearly 50% from the 52 week highs in implieds:

SPY 1yr chart of 30 day at the money implied vol (blue) vs realized vol from Bloomberg
SPY 1yr chart of 30 day at the money implied vol (blue) vs realized vol from Bloomberg

Intra-day movement like today will keep options prices decently bid, while a cooling off would cause a collapse, likely to new lows.  If you are of the mindset, as we are, that the volatility in almost every other risk asset class, and most other equity index’s around the globe (the German DAX closed down 3.25% overnight) is likely to adversely affect the SPX in the coming months then you may want to look at what we would call relatively cheap index option protection over the next few months.  If we can agree that 2050 is the line in the sand for the SPX (205 in the SPY) then in our minds thats where you want to target for disaster protection against a portfolio of large cap U.S. stocks.

Regular readers know that we think the best case scenario for U.S. stocks is that they remain in a holding pattern as we see little by way of positives that will break us out to new all time highs, the path of least resistance is no longer higher for U.S. stocks macro conditions appear to be exploding in all different directions causing investors to shoot first and ask questions later. Which we think should continue and likely cause increased equity vol in the coming months.  If 50% of S&P500 stocks are in correction territory as was reported by CNBC earlier, and the index is holding onto a 1% gain on the year, and down only about 3% from its all time highs, then we suspect that we could be on the precipice of the first 10% plus decline in the SPX since 2011.

For those who don’t want to chase their tails buying and selling their large cap equity holdings, you could consider protection in the SPY:

Hypothetical Trade: SPY ($208) Buy Oct 205 / 190 Put Spread for $3

-Buy to open 1 Oct 205 put for 4.25

-Sell to open 1 Oct 190 put at 1.25

Break-Even on Oct Expiration:

Profits: up to 12 between 202 and 190, with max gain below 190

Losses: up to 3 between 202 and 205 with max loss of 3 above 205

Rationale: 1.5% for peace of mind for your portfolio very close to where the index is currently trading down to massive support at 1900 in the SPX