The stock market has enjoyed a nearly unprecedented rebound from the February lows, gaining some 13.4% over a six-week period.
This is the second longest and largest uninterrupted rally in the last 75 years. But the nearly all the major indices find themselves at a critical juncture from both a fundamental standpoint and in technical terms.
As we enter the reporting season for first quarter earnings, both policy makers and investors alike will be looking for signs as to whether the economy is able to build any traction, or is in danger of and slipping into a recession. So far, the signs are pointing to the lack of growth in the global economy overseas and washing upon U.S. shores.
This is the main reason the Fed has taken on a such a dovish tone of late and indicated there may be no more rate hikes through 2016.
Indeed, corporations are struggling to generate any top line revenue growth as demand remains slack.
And after years of cost cutting, wages are finally creeping higher…even as productivity gains are diminishing; simply put, this means that profit margins are coming under pressure.
Initial estimates for the S&P 500 Index call for a third consecutive decline in revenues a mere 3% increase in earnings. With the S&P 500 SPDR Trust (SPY) currently around $207, the benchmark is trading at 18.9x next earnings, which is expensive on a historical basis especially in a no/low growth environment.
Th S&P 500 is now just 3% from the all-time high. But there is still massive overhead resistance in the form of the multi-month sideways action we saw during the summer of 2015. From technical perspective, there are still lower highs in place; and if the market cannot punch higher within the next few weeks, it will seem to confirm that a large top is in place and the seven-year long bull market is at an end.
If that is the case one can presume new lows will be made in coming months. On the other hand, if the market does make push through the $212 level, one could assume this will be a new and sustainable leg higher.
I’m not trying make a big prediction, but with the market at this critical juncture in both time…ahead of earnings, price, and 3% from all-time highs…I think it prudent to have some downside portfolio protection.
Buying put options on abroad index or Exchange Traded Fund such as the SPY offers the most complete and straightforward way to hedge your portfolio, but it comes at a cost. And that cost, as with all insurance policies, will be a function of the amount of protection and its duration.
The main items to consider when choosing put protection — whether for an individual stock or a broad equity portfolio — are:
- What magnitude of a decline is expected?
- At what level of the decline do you want the position in order to be fully hedged or protected?
- For what length of time do you want the protection in place?
Answering these questions will help you determine the appropriate number of puts to buy at a given strike with a certain expiration date.
What’s nice is that right now, put option premium is relatively low, meaning protection comes cheap.
Volatility levels, as measured by the CBOE S&P Volatility Index (VIX), (sometimes referred to as the ‘fear index’) have declined toward the historic lows. While the VIX can remain at low levels for an extended period, you can see we are near the baseline levels at which the probability for spikes is higher.
But even at the current low levels, put options do come at a cost. And as a decaying asset, the outright purchase of put options could have a major drag on your portfolio’s performance.
That’s why employing a strategy called a back spread, or sometimes referred to as a ratio-back spread is a good idea.
More for Less
A put back spread is constructed by selling a closer-to-the-money strike and buying a multiple number of contracts in a further out-of-the-money strike…all with the same expiration date.
The goal of a back spread is to buy as many options as possible. relative to the number sold. for the lowest cost. A good rule of thumb would be to buy 3 contracts for every 1 sold for even money.
I am not one to get to wonky, but being “net long” the number of contracts you own will translate into giving the position a profile where it benefits from a steep drop in the price, especially as bearish back spread gets shorter or more bearish as price declines.
On the other hand, by selling a higher price or closer-to-the-money put, we will have reduced the overall cost and mitigated the impact of time decay.
Another feature of the back spread is that it greatly benefits from the increase in implied volatility; something that typically accompanies a sharp decline. This is why I tend to like this strategy during periods of relatively low volatility levels and after a stock or index has become overbought or extended to the upside. Two conditions that define the current market.
SPY a Back Spread
With the SPDR 500 (SPY) currently trading at $206 and the VIX sitting near multi-year lows, I can create a low cost position that will stand to benefit of market tumbles back to the $180 level or lower within the next month or two.
The position I’m looking to establish consists of:
-Buy 3 contracts of May $192 Puts
-Sell 1 contract of May $200 Put
For $1.50 Net DEBIT for the 3×1 spread.
Here is risk graph of the position. As you can see profits accelerate the farther the SPY falls.
Also note that should a price decline come in the form of a very fast sell-off the profits will be even larger. That’s because a sharp decline will be accompanied by a spike in implied volatility, which will then cause the value of the out-of-the money puts you own to increase at a faster rate than the fewer in-the-money calls you are short.
The Dead Zone
The drawback is if there’s only a moderate decline. Assume the SPY only drifts lower and is at between $192 and $200 on the expiration. That would leave the $200 put we are short in-the-the-money, and the $192 put we own near worthless. The worst case is if shares are at $192 on expiration. I’ve market off this ‘dead zone’ by the blue box.
But also note, if shares move lower prior to expiration profits can be realized. I’ve highlighted the thin line which represents ‘current’ p/l.
Two ways to avoid ending up in this dead zone are:
- Close out the position at least a week prior to expiration IF shares are near or below the short strike.
- Or if the stock moves opposite your prediction, as in higher in this case, buy to close the short put. Remain long the out-of-the-money strikes at a discounted affective cost basis. Many times these seemingly worthless options can come back to life and produce big profits.
Back spreads are powerful positions, but they must be used judicially and traded around nimbly. Right now, with the market at a critical juncture and volatility levels low, they offer a great way to establish low cost portfolio insurance.
Steve Smith is an expert options trader with 25 years experience in the markets. Steve was a seat-holder of the Chicago Board of Trade (CBOT) and the Chicago Board Option Exchange (CBOE) from 1989 – 1997. Steve is currently the editor of The Option Specialist and runs the 20K Portfolio Program which provides all types of options trades for all types of traders.