Hedge Idea(s) – $IWM, $QQQ & $SPY

by Dan December 18, 2015 2:44 pm • Commentary

For months now it has been our view that the Russell 2000’s weak relative performance has made the etf on the small cap index, the IWM, one of the best equity portfolio hedging vehicles, at least from a bang for your buck perspective (read here from mid October.)

Weeks like this are the ones where we generally get the most inquiries about portfolio hedge ideas.  For obvious reasons, people want to protect the gains they have in a very difficult return environment. But everyone is also a little confused by the new tone at the Fed, concerned that the path of least resistance for U.S. stocks is no longer higher given the end of QE & ZIRP, have no idea what the recent decline in junk bonds could mean for stocks, or oil’s continued implosion, or the weak data out of China.

Regular readers know that we are generally not in favor of routine put protection in single stocks or portfolios, we generally like to consider stock alternatives, or overlays that help define risk. But we are in favor of tactical hedges when it appears that market uncertainty is causing a greater than usual investor trepidation, suggesting that things could be at a near term inflection point.

Given the market’s month to date declines (most major indices are down 3%) I think it makes sense to look for an early Holiday week bounce to put on portfolio protection. I also think it makes sense to consider the fact that over the last two years there have been two sell offs from some point in Jan to early Feb of about 5%.  I suspect there is a very high probability of history repeating itself in the coming weeks.

I want to quickly lay out some technical levels in the IWM, QQQ and SPY. I would like to wait for a bounce on all of these hedge ideas. Next week is a shortened Holiday week and is likely to see less panicky trading and lower implied vols. That offers a good time to get into some hedges for the beginning of 2016 for those looking to tactically protect portfolios.  The following are based on the prices and implied vols at the moment and do not reflect the better entry next wee we prefer:

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IWM ($112)

The etf’s recent rejection below the uptrend that has been in place since the 2011 lows is certainly disappointing, now approaching important technical support at $110.

IWM 5 year chart from Bloomberg
IWM 5 year chart from Bloomberg

In the coming weeks owing the $110 strike put, for protection for a 10% decline could make a lot of sense.

Hedge Idea IWM ($112): Buy Feb 110 / 100 Put Spread for $2.20

-Buy to open 1 Feb 110 put for 3.15

-Sell to open 1 Feb 100 put at 95 cents

Break-Even on Feb Expiration:

Profits: between 107.80 and 100 of up to 7.80, max gain of 7.80 below 100

Losses: of up to 2.20 between 107.80 and 110, max loss of 2.20 above 110 or about 2% of IWM

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QQQ ($111)

The Nasdaq 100 is an entirely different animal than the prior two, as 40% of the index is in 5 stocks, Apple, Amazon, Alphabet, Facebook & Microsoft, with all but Apple up substantially on year.

Aside from the extreme volatility in August and September, the QQQ has held up very well of late. I suspect investors are hanging onto gains were they have them, and that this group of stocks could see a bout of selling in the new year as investors might have wanted to book losses in 2015 and gains as quickly as they could in a new tax period.

QQQ 5 yr chart from Bloomberg
QQQ 5 yr chart from Bloomberg
Hedge Idea QQQ ($111): Buy Feb 110 / 100 Put Spread for $2.30

-Buy to open 1 Feb 110 put for 3.35

-Sell to open 1 Feb 100 put at 1.05

Break-Even on Feb Expiration:

Profits: between 107.70 and 100 of up to 7.70, max gain of 7.70 at 100 or below

Losses: of up to 2.30 between 107.70 and 110, max loss of 2.30 above 110, or about 2% of QQQ

Rationale: Again, we’re laying out the types of hedges we think make sense into 2016. We’ll revisit this post next week if we do see a little bit of a bounce in the market where implied vols would also come in. Making portfolio protection cheaper. (the strikes could change as well depending on the bounce)

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SPY ($201.50)

Nearly an identical looking chart to the IWM that tracks small caps, the big difference with the SPY is the relative out-performance from the recent all time highs, the SPY down about 5% vs the IWM down about 13%.  $200 is an important near term support, if it breaks there appears to be air pocket to somewhere between the late August and late September lows.  Seeking protection for a large cap U.S. equity portfolio looking to mitigate some risk to the prior lows makes a lot of sense given the recent pick up in volatility across risk assets and what could be a period of continued uncertainty as we head into the new year.

SPY 5 yr chart from Bloomberg
SPY 5 yr chart from Bloomberg
Hedge Idea SPY ($201.50): Buy Feb 200 / 180 Put Spread for $4

-Buy to open 1 Feb 200 put for 5.50

-Sell to open 1 Feb 180 put at 1.50

Break-Even on Feb Expiration:

Profits: between 196 and 180 of up to 16, max gain of 16 below 180

Losses: of up to 4 between 196 and 200, max loss of 4 above 200, or about 2% of SPY

Rationale:  Near term $200 is massive support, which if breaks then we are back in the area where we were during the ebola scare in late 2014 and then the EM growth scare this past August/Sept:

SPY 2yr chart from Bloomberg
SPY 2yr chart from Bloomberg

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