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Hedge S&P 500 record highs with options | Option play

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  • With stock market indices hitting record highs, you may want to consider hedging your portfolio with options.
  • Because volatility is low, buying put options can be a relatively inexpensive way to protect your position while remaining invested in the stock market.

With the stock market hitting record highs and the CBOE Volatility Index ($VIX) hitting a 52-week low, this should be viewed as a bullish outlook by all accounts.

But if you look internally, there are internal concerns about this rally, and I think we need to buy some protection from all-time highs.

Is it time to play defense?

Firstly, as Julius de Kempenaer, Chief Technical Analyst at StockCharts.com. pointed out earlier this week, if you look at the Sector Rotation RRG chart below, you can see that the rally in the S&P 500 over the past five weeks has been led by Utilities, Energy, and Staples. Although strength in the technology sector started to rise slightly this week, the overall mood in the market is clearly defensive. Materials and industrials are also rolling over, creating a lack of confidence to call a strong bull market against recent all-time highs.

Chart 1. Sector Rotation RRG Chart. Utilities, energy and consumer staples led the gains for the S&P 500.Chart source: StockCharts.com. For educational purposes.

Now, looking at the SPDR S&P 500 ETF (SPY) chart, we can see that the all-time high has not been confirmed by a new high for the Relative Strength Index (RSI) momentum indicator. This means buyers are tired and may lack the energy to continue rising. Additionally, volume has been increasing during down weeks and decreasing during up weeks, which is further evidence that this bull market is running out of steam.

Chart 2. Spy’s weekly chart. New highs for the S&P 500 are not confirmed by new highs for RSI, and trading volume has been declining for several weeks. This indicates that the bull market is weak.Chart source: StockCharts.com. For educational purposes.

strategic plan

There are two possible ways this could be implemented. Offensive sectors such as Technology, Discretionary, Materials, and Industrial may start to lead again. Otherwise, the S&P 500 may start to roll over.

I believe that trading the VIX around the 12 handle will cost you very little to buy some protection and will allow you to be fully invested in the market. This allows for additional upside participation if the offending sector comes back to life and gives up a small portion of the portfolio for hedging. And this will provide downside protection if the market rolls over.

I plan to go to expiration in July and buy a $530 put option on SPY for a $7.35 debit. This is only 1.3% of the SPY value to buy two months of protection. I choose the strike price of Delta 40. This means a profit of $0.40 for every $1 drop in SPY.

memo: Options data can be found in StockCharts on the Summary page.

As you can see, the potential reward for risk of $735 is very favorable. If SPY falls in value, the value of the put increases, all things being equal. Remember, when you buy a put option, you have the right to sell the underlying asset at the strike price before the expiration date. You can also sell your contract before it expires. If SPY is above the strike price at expiration, the contract may expire worthless and only the premium may be lost.


Tony Chang

About the author:
Tony Zhang is Chief Strategist at OptionsPlay.com, where he assembled an agile team of developers, designers, and quants to create the OptionsPlay suite of products for trading and analysis. He also developed and managed many of the firm’s expanded partnerships at the Options Industry Council, Nasdaq, Montreal Exchange, Merrill, Fidelity, Schwab and Raymond James. As a proven thought leader and contributor to CNBC’s Options Action show, Tony shares ideas on how to leverage profits while reducing risk using options. Learn more

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