Risk reversals in September: Strategy idea

Symbols mentioned: ES

Chart Source: QST

Positions: None

Is it time to hedge risk in the S&P 500?

This week has been the perfect storm for a short squeeze in equities. The FOMC decision lands tomorrow, and this morning, we received relatively good news regarding waning inflation; thus, the Fed seems destined for a pause in rate hikes. Further, the June futures and options expire at the end of the week, which is putting pressure on those who have been short and suffering to cover (buy).

That said, the buying has been position-squaring-based, not necessarily fundamental-based, and we are approaching significant technical resistance with the RSI on a daily chart near 70.00. In the short run, the market is vulnerable to a pullback.

If you want to speculate on declining equity prices or hedge your portfolio, a risk reversal seems to make sense. This is the practice of selling a call option (currently overpriced due to the relentless uptrend) and buying a put option (which is underpriced due to the low VIX reading).

Specifically, we like selling the September S&P 500 4600 call and using the proceeds to buy the 4000 put, the cost of the spread is about $50 plus transaction costs, but risk above 4600 is unlimited for speculators. If this is done as a stock portfolio hedge with an allocation similar to the S&P 500, the risk is an opportunity cost (gains over 4600 are foregone because above that price, the portfolio is gaining, but the hedge is losing, point for point). When done as a hedge, this is a strategy that offers relatively free insurance in exchange for accepting a profit cap above 4600.

A more popular but less efficient portfolio hedging strategy is to buy puts to act as portfolio insurance. This method leaves the upside profit potential open and covers the downside risk beneath the strike price of the put option purchased, but this approach can become quite expensive. For example, purchasing the September 4000 put outright would cost a little over $1,500 for just under three months of protection under 4000. With the September E-mini S&P futures contract at about 4400, the insurance would only pay off if the S&P was 430 lower at expiration (400 points to reach the strike price and another 30 to cover the premium paid); even at that price, it merely breaks even. This means the portfolio still suffered a drawdown in the amount of 400 S&P 500 points plus despite the attempted hedge. If an investor opted to buy similar insurance each quarter, he would be out about $6,000 in premium paid for puts (insurance), or about 2.5% to 3% annually, to protect against sell-offs exceeding about 10%. Most stock market corrections are 10% or less; also, most portfolios wouldn’t fare well if you shaved 3% of the top every year. Yet, a risk reversal strategy (reserved for appropriate timing) removes the cost burden of protecting the downside.

It should be noted that the CME Group offers micro-sized options against the stock indices, allowing for speculation and portfolio hedging in smaller increments. With the S&P 500 at 4400, the E-mini S&P 500s notional value is about $220,000; the micro-sized version is $22,000. Thus, those looking to hedge $22,000 worth of stocks could construct the aforementioned risk reversal strategy using the micro E-mini options.