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By: Costas Bocelli — June 10, 2021

What It Takes to be KING of the Mountain

I’ve never hiked Mt. Everest, but I’ve seen the documentaries. Looks insane to me.

When you reach really high altitudes, the air starts to get thin and really cold.

While I’ve never hiked Everest, I know that once you get to the top, there’s only one way left to go.

Today I want to talk about a different kind of mountain—the market. 

I’m happy to keep climbing the market while it makes its way up to the highest levels in history. 

It’s lucrative, and I like that.

I’m very proud and comfortable up here as the king of the mountain, I have no intention of giving up my spot. Neither should you.

To be clear, I’m not saying we’re at the top of the market. It’ll keep going up until it doesn’t anymore. The trend is up, and I follow trends.

But I haven’t made a fortune by being careless. When the footing isn’t secure, you start to tread softly.

There are signs of topping that we just can’t ignore, especially if we want to stay on top.

What’s the point of making a ton of money on a bull market just to give it all back to the bear?

By no coincidence at all, I’m an options specialist. Options are great for making money and for protecting money.

They’re a lot like insurance policies. Let’s see, like insurance, options:

  • Have expiration dates
  • Have premium values
  • Give you a right, but not an obligation

The risk is real right now, so putting some protection in place is a smart move. That’s how we’ll stay on top.

I actually talked about a similar possibility in my April 22nd, article, “Might Be Time To Add Insurance to Your Portfolio.” I was right then. The major market averages pulled back 4.21% from May 7th to May 19th.

We could see something like that again here soon.

First, let me outline some of the obvious signs of a potential correction on the horizon.

Signs of Topping

1️⃣ The Major Market Averages are Sideways

Look at the S&P 500 chart below. You can see that while the market is testing its all-time highs, it's also been trading in a sideways channel for the past couple of months, since mid-April.

(Click any image to enlarge)

The market can’t stay in a sideways trend forever, so this will have to resolve itself one way or the other.

2️⃣ Seasonal Weakness

May through October is also a seasonal period of weakness. Historically, equities tend to underperform during this part of the calendar.

Not to mention the fact that the S&P 500 has already gained 13% year-to-date, and it’s staying well-ahead of the 10% average annual return you’d come to expect since 1926.

3️⃣ Overly Optimistic Investors

Also, according to the AAII sentiment survey, investors are the least bearish about the stock market since January of 2018! 

Says a lot about investor confidence, doesn’t it? The market soon after went on to suffer one of the fastest corrections in its history. The S&P 500 fell more than 10% in just nine trading days!.

Now think about that for a moment. The market fell off a cliff right around the time when investors were far too complacent. Is this a coincidence? Hardly!

You see, sentiment surveys can be viewed as contrarian indicators, particularly when they hit extremes such as the low degree of bearish sentiment being seen right now.

Mr. Market likes to inflict the most pain as possible. So, if most folks are bullish, then he has a funny way of changing their minds. And that means the risk of a selloff is elevated.

4️⃣Our True Market Indicators Are Flashing Near-Term Caution

Then there are our major index breadth indicators. One of our shorter-term breadth indicators recently reversed down from overbought.

The S&P 500 %30 Week Moving Average reversed to a column of Os from the very overbought region of the field (above 80%), as you can see in the chart above. More stocks in the S&P 500 are falling below this key trendline (30-week or 150-day moving average). It’s seriously flashing CAUTION. It’s saying vigilance is important right now.

5️⃣ Upcoming Market-Moving Events

The Federal Open Market Committee (FOMC) policy announcement is June 16th. Committee members will update their interest rate forecasts and other economic projections like: 

Economic growth 

Unemployment rate

Inflation

There is talk that they may begin discussions on reducing asset purchases. The Fed is currently buying $120 billion a month in treasuries and mortgage-backed securities. 

Does that mean the market will have a “taper tantrum” like we saw back in 2013 when the Fed said they would begin taking away the “punch bowl?”

I don’t know. But the Fed’s hints suggest the footing isn’t great for a continued bull run in the short-term.

6️⃣ Peak Earnings, Peak Economic Growth

And finally there’s earnings, or “peak earnings.” This is as good as it gets during the return to earnings growth and economic growth.  

FACTSET expects Q2 earnings growth of +62% from a year ago. But earnings growth rates are expected to fall for Q3. Q2 is pretty much over, so the next few quarters will see notably less growth.

The same holds true with economic growth. Q2 growth is estimated to be 10%—up from 6% from Q1. That is going to be peak GDP growth quarter-over-quarter (SAAR) surely for this economic cycle.

It seems to me that the six red flags listed above are more than enough reason to think about protecting your portfolio and the wonderful gains we’ve seen during this tremendous bull run. 

So, let’s talk about how we can protect ourselves.

How to Hedge

So, if you’re not interested in giving up your upside exposure, I get it. Since the trend is up, I’m certainly not giving up my upside exposure.

But let's talk about protecting against downside risk and buying a cheap insurance policy just in case things happen to turn messy over the next couple of months.

How to Create a Portfolio Hedge Using ETFs (In Five Easy Steps)

First, ETFs are great instruments for protecting against a correction when you have a diversified portfolio of U.S. stocks.

An ETF like the SPDR S&P 500 ETF (SPY) was designed to mirror the S&P 500 benchmark index. 

With plenty of liquidity, it’s a good ETF for hedging a diversified portfolio of U.S. stocks against a correction.

I’m going to use a $250,000 investment portfolio size for this example. 

Second, we want to identify the price of the ETF.

The SPY is trading at $421.65 per share as of the close of business yesterday.

Third, we want to calculate the notional value. To determine the “notional value” of the hedge, multiply the price of the ETF by 100.

The reason is that we're going to be using Put options to build our hedge... and each Put contract represents 100 shares of the ETF.

Therefore, the notional value of this hedge is $42,165.

The fourth step is to divide the amount to be hedged by the notional value. This calculation determines how many Put option contracts to purchase.

So, if we divide $250,000 by $42,165, we can then know just how many Puts we need to purchase to properly hedge the portfolio.

The answer is 5.93. But since we can’t own a fractional option contract, we’ll simply round to the nearest whole number which in this case is six.

So, we need to buy 6 Put option contracts.

The question now is: Which Put contract should we buy? 

That’s the fifth and last step, to locate the appropriate protective Put option to buy (the strike price and expiration date).

At True Market Insider, we advocate hedging with a Put option that is at-the-money or slightly out-of-the-money, and that has about 90 days until it expires. That's the "sweet spot."

In this example, you could look to buy 6 SPY August 420 Puts. With SPY recently trading at $421.65 per share, each Put option would cost $10.75, or $1,075 per contract.

That means you’d need to spend $6,450 (or about 2.5% of the portfolio value) to create a hedge that will protect a $250,000 portfolio and offers unlimited downside protection over the next 71 days. (The Put option contract expires August 20th, 2021.)

Typically, you should look to spend no more than 3% to hedge the portfolio so this structure looks reasonable in today’s market environment.

Market volatility is relatively low right now.  With the VIX around 18, it’s still historically elevated, but at or near the lowest it’s been since before the pandemic (February 2020).

In other words, hedging against downside risk is about the cheapest it’s been in more than a year.

So, with premiums nice and affordable right now, it's a great time to hedge your portfolio. It's insurance at a discount.

Let’s make it even cheaper by selling another Put against the one we’re buying to create a Put Spread.

While this action offers limited downside protection, often you’ll find it can still provide substantial protection for a fraction of the cost.

In our example, you could look to sell 6 of the SPY August 380 Put options for $3.50 each (or $350 per contract) and reduce the overall cost of the hedge from $10.75 to $7.25—a 33% discount.

In effect, we’ve reduced the cost of insurance to $4,350 or 1.7% of the total value of the portfolio.

The limited protection effectively covers a potential selloff in the S&P 500 index ETF (SPY) down to $380 per share (roughly a 10% decline). That level also happens to be nearing a key level of support and it’s in the vicinity of the rising 200-day moving average (blue line in the above SPY chart).

This is a very smart, well thought out strategy. It’s the sort of thinking that allows you to stay the king of the mountain and enjoy the summer knowing your downside is covered.

It’s good to be KING!

Costas Bocelli

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