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By Costas Bocelli - Creator: Channel Trading Secrets
“Serenity Now!”That’s been a recurring text message I’ve been receiving from a few of my investor buddies ever since I borrowed that quip from a Seinfeld episode in The Tycoon Report a few weeks ago.
And even though my friends like to “needle me” at every chance they get, my forecast for the equity markets has not disappointed thus far.
Ever since Washington ended the government shutdown and kicked the budget and debt ceiling issues into early next year, stock indexes have been tracking higher while volatility remains subdued.
yesterday’s close of 1782 -- a rise of 25% year-to-date...
The CBOE Volatility Index (VIX) languishes...
But I have to tell you...
Even though markets should continue to track my forecasted path, I’m starting to get a little concerned, as Main Street’s enthusiasm for the stock market is really kicking into high gear.
Over the weekend, The Wall Street Journal reported that "Stocks Regain Broad Appeal" as "Individual Investors Are Returning to Stocks".
You see, ever since the credit crisis creamed Main Street, the psyche of the retail investor has been fragile. A lot of people, after all, lost a lot of money.
However, this year has produced a growing sense of confidence as retail inflows into US stock mutual funds have been the best in nearly a decade.
To me, especially as a trader with a shorter term view, the recent spike in weekly inflows is what really stands out the most.
When you see Main Street piling into stocks at the strongest weekly pace in over five years... while markets are hitting all-time highs at the same time... well, that’s usually a telling sign that a near-term top is forthcoming.
But just because the market may soon run out of steam in the near-term doesn’t necessarily mean that we should dump all of our bullish investments and short the market with utter impunity now does it?
I mean, every period of weakness that resulted in some measure of a pullback over the past few years has proved to be a buying opportunity, hasn’t it?
And that’s been particularly true of the past two years.
Just last week in The Tycoon Report (Another $1 Trillion in Stimulus May Be Coming Soon) I highlighted the fact that the S&P 500 has not seen a decline greater than 10% since late 2011.
You may click the highlighted link and revisit the article, but I pulled the chart for your quick reference:
And even though I feel that market conditions will continue to produce periods of weakness that are relatively brief and shallow, I cringed when I saw USA TODAY run this headline just a few days after my article published:
Waiting for 10% correction? Don’t hold your breath -- November 11, 2013
Talk about the kiss of death!
It’s actually been over 500 trading days since the S&P 500 index dropped over 10% from a cyclical peak, but I have to tell you -- the trading gods may soon send a jolt from the heavens to curb all the bullish enthusiasm as investor sentiment crescendos.
So, what to do?
It’s time to start hedging your gains
The reality is that the stock market has been on a tear this year -- one of the best in decades.
And while I’m still sticking to my outlook that the market should remain relatively strong over the coming weeks, it may get a more severe test than we’ve become used to lately as we move into early 2014.
You see, if Congress doesn’t agree on a budget deal by the December 13 deadline, we’re likely headed for another eleventh hour showdown, as the continuation resolution bill to fund the government expires on January 15.
The debt ceiling will also need to be addressed as the Treasury could lose its borrowing authority as early as February 7.
And last but certainly not least, the prospect of less QE may soon become a reality. There is a chance that the Fed may delay a tapering announcement at their December meeting, but some reduction in their asset purchase program is highly likely by early springtime.
That said, the prudent move may be to invest a small portion of the gains you realized and buy some downside protection.
This can be achieved by buying slightly out-of-the-money Put option contacts on individual stocks and ETFs that you own.
Or if you happen to have a mix of stocks in a portfolio that have a relative correlation to the major averages like the S&P 500, you could create a rather simple hedging strategy using the highly liquid SPDR S&P 500 ETF (SPY).
Here’s a quick example:
Let’s say you have a portfolio of stocks with a total market valuation of $100,000. And say you want to protect against a potential 10% correction that could possibly occur by the end of the first quarter of 2014. (That will capture all those potential negative catalysts we mentioned.)
No problem...
The S&P 500 closed at 1782, so a 10% correction would send the index to 1600 and likely find a level of support somewhere near the June 2013 lows. That would indeed be a significant decline, the likes of which we haven’t seen in over two years.
Looking at the SPY, which is essentially one-tenth the size of the S&P 500 index, the same decline would equate to 160 per share in the ETF.
The idea is to spend less than three percent on the hedge and target a Put option strike with a delta of (negative) 30 in our expiration cycle. In this case, the hedge is modeled using the March 31, 2014 cycle which gives us 138 days of protection.
With SPY trading around 178, the SPY (March 31, 2014) 170 Strike PUT can be purchased for 3.75 or $375 per contract. (The Put option also has initial delta sensitivity close to -30.)
Let’s say we purchase 6 Put contracts which cost a total of $2250 or 2.25% of the value of the portfolio.
Now let’s simulate what would happen if a 10% to 12% correction should happen to occur before the end of March. That scenario would see our stock portfolio lose about $10,000 (assuming relative correlation to the broad markets), but it would also put the SPY in the red shaded area below 160.
That also means that our 6 Put contracts will have increased substantially in value. And based on volatility and timing, the Put contracts can easily quadruple in value to about $1600 per contract or $9600.
That would offset a great deal of the losses in the stock portfolio, as it represents your hedge.
At that point, the Put contracts could be sold (monetized) and the proceeds could be used to accumulate additional stocks and at lower market prices.
To wrap it all up...
The market is hitting another all-time high... investor sentiment is excessively bullish... investor fear is far too complacent.
While I expect the markets will remain relatively calm as we move through the holidays, I do think that things may turn a bit choppy not too long after we ring in the New Year.
We’re closing out a great year, and hopefully your portfolio valuation is at peak performance
That said, now’s the time to consider investing a small portion of those gains to buy some downside protection, because insurance is dirt cheap.
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Costas began his trading career in 1998, at Gateway Partners, an Equity Options Trading Specialist Unit on the Philadelphia Stock Exchange (PHLX). During his successful tenure, and though unprecedentedly volatile trading levels, Costas boldly and adroitly navigated the global "financial meltdown" that saw the downfall of the hedge fund and of Long Term Capital, and the Russian Currency Crisis. Having achieved the coveted Senior Equity Options Market Maker position for his firm, Costas eventually left to join a proprietary trading desk, where he successfully makes markets for large customer and institutional orders. In addition to his more than 7 years of experience as an options market maker, Costas has also trained and educated many junior traders on option theory, risk analysis, and strategy. His passion is helping self-directed investors achieve all of their financial goals through a clear, practical understanding of the power of options and of the many benefits of trading in a proven systematic way. |
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