How to hedge the current market volatility with options
The first week of trading in 2021 gave investors a lot to digest – from the Georgia Senate run-off elections flipping the Senate to a democratic majority, questions about the stability of our democracy after the capitol was breached by angry Trump supporters, uncertainty with respect to further stimulus after potential opposition from a democratic senator in West Virginia, to President-elect Joe Biden’s plan for $2,000 stimulus checks. And oh yes, did I mention the three house democrats that drafted an article of impeachment just days before President Trump is due to leave office?
Amid the headlines, the bulls survived, with a brief Monday morning dip back below the round 3,700 level on the S&P 500 Index (SPX - 3,824.68) before the index advanced throughout the balance of the week, surpassing the 3,800-century mark in the process.
In fact, per the chart below, despite the headlines, some of which could have given the bulls pause, the SPX never breached the rising 20-day moving average, which sits below the first level of potential support on a pullback, which is the 2020 close of 3,756.07.
And small-cap stocks, as measured by the Russell 2000 Index (RUT - 2,091.66), vaulted higher in a convincing manner, surpassing the psychological 2,000 millennium level that acted as a hesitation area for only a couple of weeks. For perspective, the RUT first touched the 1,000 level in May 2013 and it was in July 2013 that it finally moved through 1,000. The 1,000 level did not go away for good, however, as it was touched again in early 2016 and early last year.
In a nutshell, last week’s headlines generated moments of heightened volatility expectations as measured by sharp intraday movements higher in the CBOE Market Volatility Index (VIX - 23.65), but bulls stood their ground.
“I find it interesting that the mid-December peak was at the VIX’s 252-day moving average. A move above this longer-term moving average in late-January 2020 hinted at major trouble ahead for stocks in February-March and another move back above this trendline in mid-October tipped off a two-week pullback in equities. At present, the VIX is not signaling major volatility in the immediate days ahead as it remains below this longer-term trendline”
-Monday Morning Outlook, January 4, 2020
Per comments I made last week and excerpted above, what stood out to me during the height of the VIX spike on Monday was that it flirted with its 252-day moving average, but never advanced above it. During the past year, this is one of several markers that I have used for hints on the future direction of volatility expectations, in addition to things like half highs, double lows and round year-to-date percentage gains as potential pivot areas.
The fact that the VIX did not above this longer-term moving average turned out to be a win for bulls as volatility expectations eventually retreated about as quickly as they surged, mirroring the December action that I discussed last week.
As a side note, the lowest the VIX got last year was roughly 10 percent below its 2019 close, which occurred in January. With the 2020 close at 22.75, the level that is 10 percent below this close is 20.48, which is only slightly above the October 2020 half high of 20.14.
Additionally, note the huge put open interest on VIX options that expire on January 20. The 18 through 22 strikes are notably put heavy, which helps make the case that a floor is in the 20 area during the next couple of weeks at least.
With the VIX slightly above its early-December low and at a one-month low, you could hedge long positions if you have not done so already.
Keep in mind that while the VIX is low when looking at a chart, it is double the SPX’s 20-day historical volatility, so hedging is still expensive from this perspective.
Therefore, if you are utilizing SPX or SPDR S&P 500 ETF Trust (SPY - 381.26) puts to hedge, consider debit spreads where you buy an out-of-the-money put and then sell a further out-of-the-money put. The upside of this strategy is that it reduces your hedging cost, but the downside is you are limited to the profit you can attain from the hedge if the market indeed succumbs to the sentiment-based vulnerability. The maximum profit, for example, is the difference in the strike prices less the premium paid.
The market’s momentum higher is still reason enough not to disturb long positions, even though risks remains from a sentiment-based perspective.
One area of the sentiment-based risk is in the actions of equity option buyers. Note in the chart below that that the 10-day, equity-only, buy (to open) put/call volume ratio has turned higher from the lows last seen in early-September, which preceded a difficult two-month period for stocks. The difference between now and early September is that the SPX began moving lower coincident with the ratio turning higher in early September. This turn higher from an extreme low should be on your radar as a continued market risk, but it may take a breach of the 2020 close or a short-term moving average to give the bulls pause.
Todd Salamone is Schaeffer's Senior V.P. of Research
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