Hedging Trade: Buying Puts on the S&P 500

Hedging Trade: Buying Puts on the S&P 500

At this point in the cycle, I am probably one of the most bullish investors in the room. I feel confident that there is plenty of room to the upside in this market, but that doesn’t mean I won’t take advantage of intermittent opportunities to go short.

 

Tactical Trading Opportunity

While I don’t think we are on the verge of any sort of serious correction, I do see the possibility of a small sell-off in the next week or so.

Equities have gone on a very strong run over the last five weeks, and the market index looks like it may roll over here. I am thinking a 2%-4% selloff.

Although a correction so insignificant may not seem like a valuable trading opportunity, options on the S&P 500 ETF SPY are trading quite cheaply, offering some compelling asymmetry.

 

S&P 500 Breaking Down

The S&P 500 index has been basing for the last nine days, and just this morning lost support and broke down from the consolidation.

Below you can see that I have measured out a 50% retracement of the most recent leg higher, which is a simple method for identifying a pullback level. This would put the target for this pullback at ~$513.50.

Image Source: TradingView

 

Finding Cheap Options

One of the most important considerations when trading options is the implied volatility. Implied volatility is a metric that reflects the market’s expectations of future price fluctuations for a security or index. It is derived from the price of options and indicates the anticipated volatility over the option’s lifespan. Higher implied volatility suggests greater expected movement, while lower implied volatility indicates less expected movement. It is commonly used by traders to gauge market sentiment and potential price swings.

The process for determining when the market favors buying versus selling an option is pretty straightforward and involves implied volatility.

Traders should buy an option when implied volatility is relatively low and look to sell options when the implied volatility is relatively high, when it fits with a trading thesis.

If you are looking to buy an option, but the IV is already relatively high, you are severely limiting the upside potential, and buying the underlying stock is likely to be the better expression of the trade.

Whereas if you are an option seller, you want to see high IV priced into the options, because it gives you a juicier premium to collect if you sell the option.

Figuring out if implied volatility is low or high can be done by looking at the IV percentile. IV percentile measures where the current implied volatility stands relative to its range over a specific period, typically the past year. It indicates the percentage of time that the IV has been lower than its current level. For example, an IV percentile of 80% means that the current IV is higher than it has been 80% of the time during the measured period, suggesting higher-than-average volatility expectations.

As of today, SPY options have an implied volatility of 14.5% and an IV percentile of 24%. This means that buying options are likely to offer an asymmetric opportunity.

 

Picking the Options Strike Price on SPY

In recent articles I have shared that I like to buy naked options, rather than spreads as it simplifies the risk management. I also noted that I typically preferred to buy 30 delta options as they offer a good balance between distance from being in-the-money, while also being relatively cheap.

I am going to share a slightly different method for picking the strike price here. Because shorting stock indexes is especially challenging (indexes are designed to go higher), I prefer to amp up the asymmetric profile of the trade.

In this case, I am looking for “lottery” type options, that have the potential to rise by multiples of the original risk, because the odds of the trade working are lower. So, for this situation, I am going to be looking to buy 15 delta options instead. Additionally, because I am betting the market trades lower, I am buying put options.

Barchart
Image Source: Barchart

SPY June 7 Long Put

Buy $515 Put @ $0.93

Upfront Trade Cost: $93 per contract

Maximum risk: $93.00 

Maximum return: infinite (on upside)

P.S. remember that each contract is quoted at the per-share rate but represents 100 shares of the underlying security.

It is also worth noting that these short-term options have big swings during the day, so prices may have changed by the time this article is published. Nonetheless, the trade should still offer a very asymmetric opportunity even if the options are a bit higher, or lower in price.

In the table below, we can see a range of potential outcomes from the trade. My target for this trade is SPY $513.50 by Monday next week. Highlighted in the table we see that if SPY can reach the target by June 3, we can expect a return of ~306% or $285 per contract.

Of course, there are a range of different possible outcomes, getting to or exceeding the target sooner, later, or not at all, with returns ranging from 580% to -100%. But most importantly, we know the maximum amount of risk built into the trade, allowing us to properly fit it into a portfolio.

A trade like this, where short-dated options are being traded, and the timeline is so short, traders need to watch quite closely. This is a very active trade, and rather high risk, so you need to be very careful with the amount you risk and be realistic about your ability to manage the trade.

OptionsProfitCalculator
Image Source: OptionsProfitCalculator

Bottom Line

For investors looking for active trading opportunities and enjoy the added complexity and potential returns of options, this is a trade worth considering.

I want to reiterate that this is a very speculative trading opportunity, and thus the risk management should be extremely strict. However, I highlight it because the payoff could be quite high, which is another good reason why you only need to risk a small amount.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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