By: Costas Bocelli — August 7, 2019
So much for that trade truce…
At the end of June, after President Trump and President Xi agreed to ease trade tensions and resume talks at the G-20 summit, investors were banking on a tranquil summer.
In fact, it started out that way.
It was smooth sailing for the bulls for much of July.
All three of the major stock market averages (S&P 500, Dow Industrials and the Nasdaq Composite) were hitting new all-time record highs in the middle of the month.
But after Trump was unsatisfied with the progress from the new round of trade talks, he surprised the markets and the Chinese on August 1st by announcing [on his twitter feed] that new tariffs on the remaining $300 billion in Chinese imports would start on September 1st.
As for the Chinese, it was a slap in the face and one that demanded a strong response.
So China quickly retaliated by devaluing their currency over the weekend.
For the first time in 11 years, the USD/Yuan currency-cross traded above 7.00.
The devaluation caused a massive global selloff on Monday, sending the Dow Jones Industrial Average lower by nearly 1,000 points intraday before closing with a 750 point loss.
It was the worst day of the year for U.S. Equities.
As for the S&P 500, the large-cap benchmark has already declined 6% from its July peak and is within 2% of breaching its 200-day moving average as of yesterday afternoon.
(Click any image to enlarge)
Now that the gloves are off, investors should be prepared for more volatility ahead.
In fact, the last time China shocked the market and devalued the Yuan was in Mid-August of 2015.
Volatility ensued and the markets were roiled well into the fall.
The S&P 500 didn’t find a major bottom until early-2016, roughly six-months later.
So will this time be different? Will the leaders of the two largest economies quickly move to diffuse the situation?
Or, are investors facing the prospect of protracted trade war?
Of course, no one can know for sure.
But if you think that things are about to get a whole lot worse, then there are steps that can be taken to protect against further downside risks while at the same time maintaining bullish exposure.
In other words, investors can take action to ride out the volatility storm with protection and see how things shake out over the next few months.
With the S&P 500 pulling back 6% off of the highs, it’s important to not lose sight of that fact that the index is still up 14% year-to-date.
So with the potential of things going from bad to worse, reaching for some insurance protection can be a prudent action.
You see, should the S&P 500 breach the 200-day moving average as we mentioned above, revisiting the lows from the winter correction is a potential outcome.
That would reflect another 18% of downside risk.
The good news is that we can take that risk immediately off the table while at the same time, preserving unlimited upside potential.
And we can do this by making one simple trade using an exchange traded fund (ETF).
So whether you’re an investor that owns a few mutual funds…
…or an investor that has amassed a sizable portfolio of individual stocks, we can protect nearly every type of composition by implementing just one options trade.
Don’t Let China Devalue your Retirement Savings (In Five Easy Steps)
Here’s how it works…
Let’s say you have a portfolio of stocks, mutual funds and other securities that are broadly exposed to the U.S. stock market.
And let’s say that the current value of the portfolio is $90,000.
As the major stock market averages fluctuate, so does the value of the portfolio.
In other words, there’s a general correlation in the performance of the stock market and your portfolio.
In this case, we can create a hedge that protects the portfolio from declining in value by purchasing protective Put options in an exchange traded fund that's tied to one of the major stock market averages.
The first step is to select which ETF you will use to create the hedge.
Since we have broad exposure to U.S. Equities, we could buy Put options in the SPDR S&P 500 ETF (SPY). The SPY closely tracks the movement of the S&P 500 index.
The second step is to identify the price of the ETF. In our example it’s currently trading around $285 per share.
The third step is to determine the notional value of the hedge.
To determine the notional value, multiply the price of the ETF by 100, because each Put contract represents 100 shares in the ETF.
In our example, the notional value is $28,500.
The fourth step is to divide the amount to be hedged (the portfolio value) by the notional value.
This calculation determines how many Put option contracts to purchase.
Since the portfolio value is $90,000, we’ll divide it by $28,500 which equals 3.16
That is the number of protective Put option contracts needed to ensure the proper amount of downside protection.
Since we can’t buy a fractional option contract, we’ll have to either round down and buy three contracts or round up and buy four contracts.
And the fifth step is to locate the appropriate protective Put option to buy, meaning choosing the strike price and the expiration date.
At True Market Insiders, we advocate the hedging “sweet spot” to be a Put option that is at-the-money or slightly out-of-the-money and has about 3-months until it expires.
In this example, you could look to buy three SPY November 282 strike Puts that cost $9.50 each or $950 per contract with SPY trading around $285 per share.
That means, to create a hedge to protect a $90,000 portfolio, we’ll spend $2,850 or about 3% of the value, for unlimited downside protection between now and November 15th, the expiration date.
There are also ways to reduce the cost of the hedge, such as selling a lower strike Put option and creating a Put spread.
While this offers limited downside protection, it is often perfectly adequate, and at the same time greatly reduces the hedging cost.
Referring back to our example, you could look to sell the SPY November 250 strike Put option for $3.00 each or $300 per contract and reduce the overall cost of the hedge from $9.50 to $6.50, which represents a 32% discount.
The limited protection effectively covers a selloff in the S&P 500 down to 2,500 or an additional decline of 12% from where the index is currently trading.
Portfolio hedging using options can be an effective strategy to manage risk for investors that own a basket of securities.
With so much uncertainty surrounding trade and fears of slowing growth, reaching for some insurance protection over the next few months may be money well spent.
In Options Soup, our options educational program, we show investors exactly how to protect individual stocks and an entire portfolio using Put options and Put spreads. To learn more about Options Soup, call 855-822-0269 or email us at email@example.com
Until next time!