Today, I want to look at a unique tactic you can use to hedge against a correction, a sell-off or worse in the S&P 500.

No matter whether you think the market will keep going higher, or worry that we’re about to lose 20% again, today’s idea will show you how to hedge your portfolio at the lowest possible cost and for the best possible gain.

My first point – this week’s content has explored current and future valuation for the S&P 500; hedging the S&P 500 as an investor (buying inverse ETFs for short-term gains); and, the ‘mixed message’ we’re getting across a breadth of market and financial data.

Second – note that our focus is primarily on a short-term sell-off or correction in the major indexes, not a resumption of the bear market.

Corrections are healthy and normal, so the question is how can you use them to your advantage? Today we’ll consider a variation on a Put spread tactic using the SPDR S&P 500 ETF (SPY).

We’ll use the SPY because traders of any account size can trade it due to its lower cost profile and because it has enough liquidity, volume, and strikes to support trades. Large portfolio traders can replicate this tactic with the SPX, but the cost differential is extreme.

Let’s identify key support/resistance levels in the SPY first:

Resistance has formed at 455.
Four key support levels: 450, 445, 435 and 430

445 is to me a line of support which needs to be tested as the SPY pulled away vertically from that level (third red line on the chart below).

430 is a strong line of support given the six-days of resistance that price level provided before breaking above.

With these levels we can project (not predict) the following:

The table above provides SPY price levels based on corrections ranging from -2.5% to -10%.

A small 5% correction, you can see, is consistent with the 430 line of support (the 420 and 410 lines would also be consistent with a deeper correction, too, but that was too bearish for me right now.)

And, the SPY would have to sell off through 445, 440 and 435 … so knowing this, we can build a trade to hedge the SPY which allows us to capitalize on the way down.

The Inverted Ladder (Vertical Put Spreads): This is a debit trade.

Basic theory: Buy key support levels in SPY using vertical put spreads (buy/sell puts in the same trade – the sold puts offset the cost of the bought puts). 

As the market corrects, each rung (or support level) in the ladder “breaks” creating a profitable trade by increasing the value of the lower rungs.

The hard part to think through is this:

At the upper end of the ladder, you are “buying high, selling higher” (when long on a put, as the market pulls back, the value of the put continues to rise).

At the lower end of the ladder, you are “buying low, selling high.” Everyone gets that part, right?

The challenge – as always – is TIME.

So here’s a trade we constructed which builds in protection at the lowest possible cost, gives us time value for the market to correct and has a reasonable profit profile.

THIS IS NOT A TRADE RECOMMENDATION – YOU CAN REPLICATE THIS MODEL 

I’m adding that line for two reasons:

1. I’m writing this article at 7am on Thursday (7/27) – by the time you read it, prices will have changed
2. When we constructed the trade, it was at market close Wednesday (7/26)

Rung 1: (Net debit: $3.66 or $366 per contract)

Buy 25 AUG 460 Put
Sell 25 AUG 450 Put

Rung 2: (Net debit: $1.57 or $157 per contract)

Buy 25 AUG 450 Put
Sell 25 AUG 440 Put

Rung 3: (Net debit: $ .59, or $59 per contract)

Buy 15 SEP 440 Put
Sell 15 SEP 435 Put

Run 4: (Net debit: $ .46 or $46 per contract)

Buy 15 SEP 435 Put
Sell 15 SEP 430 Put

Total Net Debit: $628 per contract

Potential Capital Allocation on a $50,000 portfolio or trading account: 2.5% or $1,250 or 2 contracts (roughly, you’ll be over by $6 – I think we can handle that).

The Explanation:

Usually when buying options at or in the money, most traders go OUT in time; notice here in Rung 1 we’re only going out 30 days, which means ANY move lower in the SPY will increase the value of the Rung 1 PUT spread (that’s the buying high, selling higher).

So, what we did here is to buy in/at the money with our 30 Days to Expiration Puts and buy up to 2.5% protection in the S&P 500 (from 460 to 440 – note in the previous table, 444 is the current -2.5% correction level).

We’ve also built protection up to the 5% correction with the lower 2 rungs and we are using TIME to our advantage with an extra 15 days to expiration.

A move in the SPY to 440 would increase the value of the top three rungs; and if that move can happen in just 2 weeks (to around Aug 11) the profit of this trade would be $1,217 per contract, a near 2 to 1 payoff.

In fantasyland, the maximum profit on this trade would be nearly $3,900 (but that’s fantasyland. It isn’t going to happen).

What that max profit potential does tell us, though, is we can have some patience to let the market correct and we can use time value to determine when we should close any or all of the rungs of the trade.

As well, by limiting the capital out, we’re not exposing ourselves to significant risk.

Our max loss is our net debit; no more. That’s what a hedge is: a cost-controlled insurance policy; a break-glass-in-case-of trade.

The Inverted Ladder, as we’ve constructed it, is meant to be a simple trade with a unique application.

On Monday, we’ll take a look at other variations of this trade and how you can replicate this in your trading, and some profit-taking strategies.

Enjoy your weekend!

John Hutchinson
Traders Reserve