Hedging the S&P All-Time Highs With Options

As equity markets print new all-time highs and the CBOE Volatility Index ($VIX) prints 52-week lows, this should be considered a bullish outlook by all accounts.

However, when you look under the hood, the internals with this rally concern me and, in my opinion, warrant buying some protection at these all-time highs.

Time to Play Defense?

Firstly, as Julius de Kempenaer, Senior Technical Analyst at StockCharts.com pointed out earlier this week, if you look at the Sector Rotation RRG Chart below, you can see that, over the past five weeks, the rally in the S&P 500 has been led by Utilities, Energy and Staples. While Technology has started to show a slight increase in strength this week, the market’s overall tone is clearly in defense. With Materials and Industrials also rolling over, we simply lack the confidence to call a strong bull market on the recent all-time highs.

CHART 1. SECTOR ROTATION RRG CHART. Utilities, Energy, and Consumer Staples led the rally in the S&P 500 index.Chart source: StockCharts.com. For educational purposes.

Now, if you look at a chart of the SPDR S&P 500 ETF (SPY), you see that the new all-time highs were not confirmed with a new high on the Relative Strength Index (RSI) momentum indicator; this suggests that buyers are exhausted, and may lack the strength to continue higher. Additionally, volume has been increasing on down weeks and decreasing on up weeks, which is further evidence that this bull market lacks strength.

CHART 2. WEEKLY CHART OF THE SPY. The S&P 500’s new highs have not been confirmed by a new high in the RSI, and volume is declining on up weeks. These indicate that the bull market doesn’t have strength.Chart source: StockCharts.com. For educational purposes.

Planning Your Strategy

There are two possible ways this can play out. The offensive sectors, such as Technology, Discretionary, Materials, and Industrials, can start leading again; alternatively, the S&P 500 could begin to roll over.

With the VIX trading around the 12 handle, my view is that it costs us very little to buy some protection, and it would allow you to remain fully invested in the markets. This would allow further upside participation if the offensive sectors returned to life, while giving up a small percentage of your portfolio for the hedge. And this would provide downside protection if the markets were to roll over.

I’m going out to the July expiration, and buying the $530 puts on SPY for a $7.35 debit, which is only 1.3% of SPY’s value to buy over two months of protection. I’m choosing a strike price with a delta of 40, which translates to $0.40 of profits for every $1 drop in SPY.

Note: Options data is available in StockCharts in the Summary Pages.

As you can see, the potential reward for risking $735 is very favorable. If SPY declines in value, all things equal, the put’s value will increase. Remember, when you buy a put, you have the right to sell the underlying at the strike price before expiration date. You could also sell the contract before expiration. If SPY is above the strike price at expiration, you can let the contract expire worthless and just lose the premium.