Let’s grab a cup of joe. A gargantuan rally in the markets of 13% of December 2018 lows and the S&P 500 (SPX) is within roughly 1% of the magnetic round number of 2700. Considering the US-China trade war, the government shutdown and the twitter warning by the US Commander and Chief “You want to see a stock market crash, impeach Trump”, this market has shown incredible signs of resiliency. Though I may not have an overflow of supporters in calling for us having seen a high, the more I watch price action the more I believe we are about to see the cameo appearance of volatility. The SPX closed the week at 2670 and if I had to pick sides of getting long or short this market, I would be getting short.
This week, we sent updates to Insiders illustrating a clear bias to the downside. From the SPX hedge taking us out to February 15th, to us looking to capitalize on the anticipated interim high we should be getting before January is through. Is that what we saw? In all honesty, it could really go either way. All we can do be prepared and have our hedges in place. This applies to indexes as well as the stock we own.
For example, everyone knows (and maybe loves) Apple (AAPL). Let’s say we owned AAPL stock and we were holding it for the long term. For whatever reason, we aren’t going to be selling it anytime soon. Given where AAPL is and taking volatility into consideration, we can use options in AAPL or even indexes to protect the money that we have invested in AAPL. How? By the use of put spreads in either AAPL or an index. What!? Spreads you say!? You see typically, investment and portfolio managers (not all, because I know a good few that are a tad savvier) will use the purchase of a single put (the buying of a right to sell a stock at a certain price by a certain date). A put spread is when we buy that right to sell a stock at a certain price and have the obligation to take ownership the stock at a certain price below it. It’s safer and more cost effective. I know it can be a bit confusing so let’s bring a hypothetical into the mix.
Suppose AAPL is trading at $100/share, and we bought it at $80. We do not want to sell our stock, so how do we implement the put spread? We buy the 100 put and simultaneously sell the 95 put, so we own the right to sell AAPL at $100 and have the obligation to take ownership of it at $95. Now, because we own the right (at $100) prior to us taking on the obligation (at $95) our risk is finite and predefined. If and when AAPL falls in this hypothetical example, the profit on the put spread will help recoup the downside we have seen the value of the stock and profits realized on the put spreads can then be used to buy more shares for no additional money. This can be done in registered retirement savings accounts, tax-free savings account and do not require you to be at your screen watching the markets.
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Risk & Reward
We used the SPX to hedge our long positions this past week. Provided we get a modest 1% decline in the market, we will start yielding a profit. If this market keep going? Not to worry, we have time on our side.