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SPY Hedgers Should Go Big or Go Home

Why now is a good time to hedge with out-of-the-money SPY puts

Editor-in-Chief
Jan 15, 2018 at 8:24 AM
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While there's certainly no sign yet of a breakdown in the record-setting rally that's been the dominant post-election storyline for U.S. stocks, bulls can be forgiven for feeling an increasingly urgent desire to hedge some (or all) of their long equity exposure. Geopolitical risk and uncertainty continue to dominate daily headlines; the CBOE Volatility Index (VIX) remains unusually low, as discussed a week ago in this space; and -- after the relative calm of this long holiday weekend on Wall Street -- the rush of corporate earnings kicks off in the week ahead, and a number of Dow components are among those set to report fourth-quarter results.

And for those tracking the SPDR S&P 500 ETF Trust (SPY - 277.92) on its journey to all-time highs, it's perhaps a little worrying that the exchange-traded fund (ETF) registered a 14-day Relative Strength Index (RSI) reading in the neighborhood of 84 on Friday, marking the indicator's second trip above 80 in 2018, and its first serious incursion on 80-plus territory since late in the first quarter of 2017.

Notably, the RSI surge into the low 80s that took place during late February and early March last year immediately preceded a slow grind lower through the final days of the quarter (which the 20-day failed to catch, but the 50-day effectively contained). The SPY faltered lower again into mid-April before elbowing its way back to new highs by late May, with a couple of key assists from its 80-day moving average in the process.

This chart-based "red flag," coupled with the as-yet-unquantifiable risks to various sectors and big-cap, market-leading equities presented by the upcoming slate of fourth-quarter earnings, makes a solid enough case for a SPY hedge -- but perhaps it's the rock-bottom volatility skew on SPY options that truly seals the deal. In the immediate aftermath of Friday morning's "yet-another-record" high for SPY, the fund's 30-day implied volatility (IV) skew checked in at 16.6%, in the 1st percentile of its annual range.

In the simplest terms, that means short-term SPY puts have rarely priced in a lower volatility premium relative to SPY calls -- and to be clear, it's exactly the type of development you'd reasonably expect to see when SPY is locked in a long-term, low volatility uptrend to new highs. But it's a development worth taking advantage of, for those looking to purchase some short-term put protection for a portfolio heavy on long U.S. equity positions.

To be more specific, it's 10% out-of-the-money (OOTM) put options on SPY that are priced to move right now. As of Thursday's close, the 10-day moving average of the 10% OOTM put/call skew was at 1.642 -- near the low end of its recent range, and as compared to 1.765 for 5% out-of-the-money options.

And favorable volatility premiums aren't the only reason for equity hedgers to target "crash protection" over "pullback protection." Based on Friday's closing SPY level, a 5% decline would leave the ETF comfortably north of multiple layers of long-term trendline support, presenting very little immediate cause for concern on the part of bulls. By contrast, a 10% drawdown would place SPY below its 80-day moving average, and would set up a potentially "do or die"-type showdown with both the round 250 half-century level and its benchmark 200-day moving average.

spy daily rsi 2-year


Subscribers to Bernie Schaeffer's Chart of the Week received this commentary on Sunday, January 14.
 
 

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