Share:

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).

Chart

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.

Due to the volatile nature of the futures markets some information and charts in this report may not be timely. There is substantial risk of loss in trading futures and options. Past performance is not indicative of future results. The information and data in this report were obtained from sources considered reliable. Their accuracy or completeness is not guaranteed and the giving of the same is not to be deemed as an offer or solicitation on our part with respect to the sale or purchase of any securities or commodities. Any decision to purchase or sell as a result of the opinions expressed in this report will be the full responsibility of the person authorizing such transaction.

Follow us on Telegram

Stay updated of all the news

Join Telegram

Editors’ Picks

EUR/USD stays in daily range near 1.0850 ahead of US data

EUR/USD stays in daily range near 1.0850 ahead of US data

EUR/USD holds steady at around 1.0850 after edging higher on hot French and Spanish inflation data in the early European session on Thursday. The market action remains subdued as focus shifts to inflation figures from Germany and the US.

EUR/USD News

GBP/USD holds ground above 1.2650, awaits US PCE inflation data

GBP/USD holds ground above 1.2650, awaits US PCE inflation data

GBP/USD is holding ground above 1.2650 in the European trading hours on Thursday, as the US Dollar remains on the back foot amid a better mood and sustained USD/JPY sell-off. The focus shifts to the US PCE inflation data for fresh USD price action. 

GBP/USD News

USD/JPY moves lower to near 149.80, focus on US PCE data

USD/JPY moves lower to near 149.80, focus on US PCE data

USD/JPY loses ground on risk appetite ahead of US PCE data. JPY received upward support on hawkish remarks from BoJ’s Hajime Takata. The US Dollar experiences a decline despite the improvement in US Treasury yields.

USD/JPY News

Follow us on Telegram

Stay updated of all the news

Join Telegram

Editors’ Picks

EUR/USD stays in daily range near 1.0850 ahead of US data

EUR/USD stays in daily range near 1.0850 ahead of US data

EUR/USD holds steady at around 1.0850 after edging higher on hot French and Spanish inflation data in the early European session on Thursday. The market action remains subdued as focus shifts to inflation figures from Germany and the US.

EUR/USD News

GBP/USD holds ground above 1.2650, awaits US PCE inflation data

GBP/USD holds ground above 1.2650, awaits US PCE inflation data

GBP/USD is holding ground above 1.2650 in the European trading hours on Thursday, as the US Dollar remains on the back foot amid a better mood and sustained USD/JPY sell-off. The focus shifts to the US PCE inflation data for fresh USD price action. 

GBP/USD News

Gold price consolidates as focus remains on US core PCE Price Index

Gold price consolidates as focus remains on US core PCE Price Index

Gold price awaits the US core PCE Price Index data for a decisive move. The underlying inflation data will sharpen the interest rate outlook. Fed’s Collins expects the Fed’s path to 2% inflation will be bumpy.

Gold News

XRP price surges to $0.58 amidst allegations of price manipulation by Ripple using bots

XRP price surges to $0.58 amidst allegations of price manipulation by Ripple using bots

XRP price continued its rally towards the $0.64 target on Thursday. The altcoin climbed to $0.58, sustained above key support at $0.55, maintaining its uptrend.

Read more

Canada GDP Preview: Economy expected to have resumed expansion in Q4

Canada GDP Preview: Economy expected to have resumed expansion in Q4

Following the annualized 1.1% contraction recorded in Q3 2023, the Canadian economy is predicted to have performed very well in the latter part of last year, growing by 0.8% and prompting the BoC to maintain its prudent monetary policy stance.

Read more

RECOMMENDED LESSONS

7 Ways to Avoid Forex Scams

The forex industry is recently seeing more and more scams. Here are 7 ways to avoid losing your money in such scams: Forex scams are becoming frequent. Michael Greenberg reports on luxurious expenses, including a submarine bought from the money taken from forex traders. Here’s another report of a forex fraud. So, how can we avoid falling in such forex scams?

What Are the 10 Fatal Mistakes Traders Make

Trading is exciting. Trading is hard. Trading is extremely hard. Some say that it takes more than 10,000 hours to master. Others believe that trading is the way to quick riches. They might be both wrong. What is important to know that no matter how experienced you are, mistakes will be part of the trading process.

Strategy

Money Management

Psychology