Hedging Conviction with Confidence

The S&P 500 is now red for the year and we are allegedly in the midst of a commodities collapse. Traders just witnessed a gigantic one-day rally in Treasuries as 10-year yields tanked all the way down to 1.86% Wednesday morning and have since recovered to 2.06%. Meanwhile the VIX, Wall Street’s fear gauge, has surged 24% in one day and is flirting with levels not seen since the 2011 sovereign debt crisis.

We are in the midst of a growth scare and, whether you choose to believe it or not, until there’s a force or event to counter it, the negative momentum will continue to hewn the trap doors for investors and traders to fall through.  These are times when stocks become afraid of their own shadow and when traders begin to view market volatility like a vicious watchdog that can’t seem to stay on the porch.

Is it too late to hedge with options?

Understand it’s never too late to hedge!  Market drops and higher implied volatility presently make things more complicated and, more expensive.  However, by their very nature, optionality can potentially provide you with unique opportunities to express your conviction in a smart and risk-adjusted manner.  Below, are two options trades that could help stave off additional losses in the market.

Trade One: SPDR S&P 500 ETF (SPY) Reference Price: 184.40

Trade:  Purchase the November 187.00 / 181.00 Put Spread for $2.22 per spread.

Due to the huge demand for downside puts, SPY skew levels, or the implied volatility of out-of-the money puts vs. at-the-money puts, have become tragically high.  This put spread would take advantage of the high skew level (you would be selling skew), while expressing your conviction of hedging downside exposure.

• Cost: $2.50 or $250 per spread with 37 days till expiration.
• Break-even point: 184.50
• Downside: $250 or price you paid for spread.
• Maximum profit point: 181.00
• Maximum profit: $350 (difference between 187 & 181 strike price minus 2.50 premium paid).

Trade Two: VOLATILITY S&P 500 (^VIX) Reference Price: 28.21, November future reference: 21.73.

 Trade: Purchase the November VIX 23.00 call for $3.00.

VIX is in deep backwardation: A market condition in which the futures contract is trading below the expected spot price. Whereas the VIX is trading at a 6.48 premium to the November future.  This is due to many factors and, is not completely out of the ordinary – just a little more “backward” than normal.  Given this abnormality, you are able to buy November options premium at a perceived discount to the rest of the options curve.  There is never any free lunch – this may end up being a cheap one!

• Cost: $3.00 or $300.
• Break-even point: $26.00
• Downside: $300 or the price you paid for the calls
• Maximum profit point:  Unlimited