Despite a week of good news, after hours S&P Trading on Thursday evening provided flat trading. It’s a bit disconcerting that with 4 of the 8 largest capitalized stocks in the S&P 500 not only rising in price, but exceeding expectations, the overall market was unable to pick up any substantial steam in Friday’s trading. The E-mini closed Friday’s session with a gain of about six points.
This might be the perfect opportunity for traders to consider hedges or short positions in stocks. If that type of position is something you are thinking about, there are numerous ways to establish short positions in either the E-mini S&P or SPY (SPDR S&P 500 ETF Trust) using options strategies which can mitigate risk or establish a short position. If markets can’t rally with good news, then the likelihood is that they will go lower.
There are several ways to use options trading to develop a position to meet your risk/reward requirements. One extremely popular vehicle for protecting downside risk is through the trading of the VIX Options (CBOE Volatility Index). Futures contracts are also traded on the volatility index and VX (CBOE Volatility Index Futures) represents the implied volatility of S&P Options. In addition, the VIX provides options on numerous Strike Prices which, by purchasing Calls or Call Spreads on a particular series of options, creates an opportunity to protect an equity portfolio. While the VIX is an intriguing product, on lower priced options the liquidity of the product, despite its substantial volume, can be cost prohibitive. If you are establishing the position as a long-term trade and determine that it is a reasonable value, then the VIX, particularly at its current low price level, can be an appropriate hedge against long stock portfolios.
The Table below provides a view of September VIX options prices towards the end of the day on Friday. I have also included the futures price associated with the underlying VIX options contract. If you’re looking at the cash price of the VIX and trading the various months that are traded, the price of the options can be confusing. Always be sure to look at the month associated with the VX (CBOE Volatility Index Futures) when making your trading decisions. As you can see in the example, the September options series trades at a price significantly above the current cash price (which is shown on the top right). By merely taking the difference of the Bid/Ask spread and dividing it by the offer price, you get a comparable liquidity percentage. Compare that with other options you are trading to consider if the market is tight enough for you.
While options trading provides a multitude of methodologies to get short any market, the liquidity and Implied Volatility Skew of the E-mini S&P enables traders to either hedge or get short the S&P 500 with liquidity and value. Given the market’s lackluster response to solid earnings results from Amazon, Apple, Facebook and Google, I have attached a strategy which may be used as a guide for establishing a short position with good value. If the market continues to rise, you will lose money on the hedge but make money on the balance of your portfolio that is not hedged. If you use it to establish a short position, you have a defined risk/reward scenario. For a greater understanding of these concepts, Contact Us for an educational webinar to dramatically increase your options learning curve.
The strategy, shown below, involves selling a September Call Spread and buying a September Put Spread. The details are in the Table. The key to the strategy is that you derive an implied volatility advantage on each spread you execute. By purchasing the Put Spread you buy an option with a lower implied volatility than the one you sell. The same is the case in the Call Spread. Analyzing options which meet liquidity standards, evaluate historical and implied volatility and the implied volatility skew are essential in utilizing the appropriate strategy to meet your trading needs.
Despite all the good earnings news this week and large cap stocks trading higher, the S&P 500 put in a lackluster performance on Friday. This may be a call to action for hedging your portfolio. Options analysis and trading can provide numerous methodologies to meet your objectives. The two markets discussed above, in a relatively limited way, are just the tip of the discussion for what may be appropriate for you. If you have any questions, Contact Us.
Options trading involves significant risk and is not suitable for every investor. The information is obtained from sources believed to be reliable, but is in no way guaranteed. Past results are not indicative of future results.