MicroStockHub/iStock via Getty Images
S&P 500 (NYSEARCA:SPY) has been in a raging bull market since last October and it’s been within 5% of its all-time high. I would absolutely advise against shorting it or selling your investment at the moment when the momentum is so strong and sentiment is very bullish, but it may be a good time to put some hedges to protect your portfolio. The good news is that VIX is so low that hedging your portfolio hasn’t been this affordable in a long time.
Data by YCharts
Before we begin, let me mention 3 special dates to you. These are May 23, 2023 (2 months ago), March 9, 2023 (4.5 months ago) and August 26, 2022 (11 months ago). What’s so special about these dates? Well, May 23rd is the last time SPY was down at least -1%, March 9th is the last time SPY was down -2% and August 26th was the last time SPY was down -3%. In other words, SPY hasn’t had a -1% day in 2 months, hasn’t had a -2% day in 4.5 months and hasn’t had a -3% day in 11 months. Even in raging bull markets this is very rare.
For example in 2020, between March 2020 and the end of the year, SPY rose from $220 to $400, having one of the best 9-month performances in its history but even during this period we’ve had 31 days where SPY was down at least -1%, 15 days where SPY was down at least -2% and 8 days when SPY was down at least -3%.
Data by YCharts
This time we’ve been going straight up without a single correction, pull back or any profit taking. As a result, VIX is now at the lowest level it’s been since 2019. This is also good news for investors who’d like to hedge their portfolio because option contracts haven’t been this cheap in years.
Data by YCharts
You might be inclined to think that since SPY has been up so much since October, corporate earnings must also be up but you’d be surprised to find out that corporate earnings are actually down right now. Just because companies are beating lowered estimates doesn’t mean their earnings are growing.
S&P 500 earnings growth YoY (multpl.com)
If stocks are rallying but earnings are falling, this means the stock rally comes from multiple-expansion (also known as P/E expansion). Typically P/E expansion happens when investors are willing to pay more money per each dollar a company generates in earnings. P/E expansion usually happens for a few reasons. First, they happen in an environment when rates are falling. For example, if interest rates suddenly drop from 5% to 2%, stocks get a higher multiple because discount rate of risk-free investments dropped significantly. Right now we are actually witnessing interest rates rising rather than falling which makes this multiple expansion even more odd.
SPY P/E ratio by month (Author (on Excel))
Another reason we could see P/E expansion is when a company changes its business model or creates a revolutionary product where investors now believe it deserves a high multiple. Two examples that come to mind are Apple (AAPL) and Microsoft (MSFT). These two companies enjoyed low P/E ratios in low-to-mid teens for much of last decade but their P/E suddenly started climbing around 2019. Apple’s P/E started climbing because investors realized the potential of Apple’s app market and its recurring revenue potential beyond selling phones and Microsoft’s P/E started climbing because investors realized the growth opportunities in cloud and SAAS (software as a service) model Microsoft was adapting at the time.
Data by YCharts
When a company’s P/E suddenly expands, it can be explained by looking at its new products, services and opportunities but not when the entire market sees its P/E expand drastically especially while interest rates are also rising. In January 2022 SPY earnings yield (average P/E ratio reversed) had a premium of almost 3% over treasury yield but now it has none because SPY’s earnings yield dropped while treasury yields increased.
SPY earnings yield vs treasury yield (Author)
Finally when you look at the biggest components of SPY (accounting for almost 30% of the total weight), almost all of them had a significant P/E expansion since October ranging from 40% to 500%.
Data by YCharts
People say “it’s just tech” but not really. Below are some non-tech large components of SPY that saw significant P/E expansion lately, ranging from McDonald’s (MCD) to Costco (COST).
Data by YCharts
Having said this, you don’t want to short SPY or sell it. In the long term, buying and holding wins. It’s even better if you can reinvest dividends and buy the dip over time to improve your dollar-cost-average. Still, you want to hedge your positions when the market is both technically overbought and fundamentally overpriced. When the market hasn’t had a solid red day in a long time and it has a generously high valuation, you want to be protected.
So, how do we protect our SPY position? There are multiple ways to do this.
1. Buying puts
You can buy puts plain and simple but there are things you have to decide. First, are you buying them at the money or out of money? If buying them out of money, how deep are you going? Another thing to consider is timing. Are you buying them a month out or a year out? Long term puts offer more protection buy they also cost more.
Currently SPY is at $455. Applying a 10% discount gives you $410. This is can be considered a good spot. If you buy $410 puts a month out (expiring on August 25th) they cost only 38 cents which is $38 per contract. If you go two months out, the same contract costs $1.52 or $152 per contract. If you go three months out, you are looking at $2.22 or $222 per contract. Notice that when you go from 1 month to 2 months, the price triples but when you go from 2 months to 3 months, it only increases by 50%, which means you probably get more value if you go 3 months out.
Let’s say you bought $2.22 contracts and SPY took a -5% dive on the next day. Now SPY sits at $432 and your $2.22 contract would be theoretically worth $3.45 because the delta of October $410 puts were 0.10 which means for each $1 SPY drops, this put would gain 10 cents in value. But there is more. This option also had a Vega of 0.39 which means for each 1 point rise in VIX, the option would gain 39 cents. If SPY were to take a 5% dive, this would result in VIX easily doubling from current 13 to 26. This would add another $5 to our option value (13 x 0.39) so now our puts are worth $8.50. It still doesn’t protect fully since in this scenario SPY dropped $23 per share in value but some protection is better than nothing. Also, if SPY were to drop another 5-10% from there, our puts would show more protection power.
SPY $410 October puts (Nasdaq)
The biggest risk for this type of strategy is if SPY drops just above your put strike price, you lost all the premium you paid for your put option plus the downside on your shares. For example if you bought $410 puts for $2.22 and the stock just dropped to $410.01, you will have suffered all this downside plus $2.22 and it will be fairly expensive to roll your put option for longer since VIX will likely be higher.
2. Buying put spreads
Buying put spreads is a cheaper way to protect your portfolio. Instead of buying October $410 puts for $2.22, you can buy a $440-420 put spread for the same price or a $430-400 spread for $2.11. Notice that $440-420 spread is $20 wide but the $430-400 spread is $30 wide but they cost about the same. This is because when you buy the second spread you make a trade off where your protection kicks in at a lower price ($430 vs $440) but you get more protection in return ($30 vs $20). In the first spread, you are protected until SPY drops to $420 and in the second spread you are protected until SPY drops to $400. In theory you could always roll these spreads down and keep the protection alive for longer though. For example if you did the $440-420 spread and SPY suddenly dropped to $440, you could roll it down to $420-400 spread for no additional cost (in fact you’d be receiving a credit). If you are fine with actively managing your options, this could be the way to go.
The risk with this approach is that if SPY is just above the top part of your spread when your spread expires, you will not get any protection and you will lose out on any premium you might have paid to initiate your position.
3. Buying VIX calls
Alternatively you can buy out of money VIX calls. In theory VIX should rise sharply in case of a market correction so you can take advantage of this move. Not many brokerages offer VIX options and many people use VIX ETFs instead but I don’t recommend this route because VIX ETFs are usually leveraged and they don’t follow VIX perfectly. For example below you can see the performance differentiation between VIX and a highly popular ETF called VIXY (VIXY).
Data by YCharts
The biggest risk for this approach is the fact that VIX options tend to be pricey even when VIX is low because when VIX is low, expectations for VIX to climb are higher due to “regression to the mean” principle. Also, it is possible that the market can bleed slowly without raising VIX too much. If the market were to drift lower in slow motion, your VIX calls might not offer much protection and you might still suffer downside (plus the money you spent on VIX calls).
4. Calendar put spread
In this play you buy a put option out of money and sell a put option at the same strike price but at an earlier date. For example you buy SPY $400 put expiring in January and sell SPY $400 put expiring in October. The option you bought would cost $4.47 per share and the option you told would bring in $1.73 per share which means the cost of establishing this position is only $2.74 per share. That way if the correction doesn’t happen and the market keeps rallying until January, you lose less money on your hedge. Also, this play has a sweet spot of $400 and it offers maximum protection at $400. If SPY were to drop below $400, you’d have to roll your position down. Keep in mind that your short option will expire 3 months before your long option does which means you can keep selling short-term puts against your position for another 2 months to reduce your cost basis. For example once October comes, you can roll your short $400 puts to November for some additional cash.
Profit-loss profile of calendar spreads (Options Profit Calculator)
The biggest risk for this approach is that since longer dated options have higher Vega values they are more dependent on volatility. If VIX suddenly drops significantly, your long put option might lose more in value than your short put option due to Vega differential. Also if the stock suddenly drops below your sweet spot (in this example $400) your protection wears off and you might actually start losing money on your hedge. This is a position you have to watch very closely and make sure you are ready to adjust when needed.
There are other methods that can also offer partial protection such as selling covered calls or call spreads against your position or doing an iron butterfly but these offer limited protection and can limit your upside. Also, there is little benefit of selling covered calls when VIX is so low and options are so cheap. I am usually not a fan of buying puts for protection because it can cost a lot to keep buying them every month but this could be an opportunistic time since markets haven’t had a meaningful correction in such a long time, they are technically overbought and fundamentally overpriced, not to mention VIX being at historically low levels provides some cheap put buying opportunities in my view.
Source: seekingalpha.com
