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4 Aug 2019

Introduction

We have been waiting for it and maybe the time has come. More tariff threats from the Twitter in Chief, earnings are nearly over with good results and poor forecasts and international unrest may be combining for the perfect summer storm. August is known for low volume and lazy trading. We will see.

We will take a look at some possibilities to take advantage of a downturn as we monitor our hedges for an appropriate exit. We are now over 60% in cash so our hedges can be more about profiting than protecting as we exited a bit early while being pleased with the outcome.

Over the course of July the S&P gained -0.39% with the peak around mid-July at 20.10%. We managed +1.69% and 18.59% respectively. To the extent we can manage to retain wins better than the S&P we can deliver on Alpha.

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Background

Identifying a selloff is challenging.

Our SPX chart is getting increasingly busy as more support levels reveal themselves. As noted in the June and July monthly updates, we have been planning for a typical pullback of 5-10%. As of the close on 2 August, the S&P is 3.2% off the high. It is clear from the chart that this decline has been quick: just 5 days in the making.

The SPX bounced off the 2916 level; Monday may tell us a great deal.

The market does not go up in a straight line or down in a straight line. We could see a little recovery, depending on weekend Tweets and news; that would not change our thesis that the correction is near. Finishing next week above 2916 would likely put the lie to the thesis.

The weekly SPX shows a more negative picture to the downside; the monthly has a bearish engulfing bar indicating even more negative potential.

Where to from here

There is nothing that keeps us from making a few shekels on the downturn. First priority, however, is to capture gains and take a defensive posture. One of the clear ways to deliver Alpha is to take less of a hit on corrections than the indexes do.

Let's take a look at what we might do, the costs and risks to use different tactics in a falling market. For each tactic we will look at 100 shares of the underlying equity as the comparative case.

Going Short

Not all accounts allow shorting equities. For those that do, we will look at shorting the SPY as a market tactic and shorting AMZN as a volatile stock tactic.

SPY

Selling 100 shares of SPY short would put a lock on about $29,000 in our account. Most brokers simply assume the equity will go to zero and hold that amount of margin hostage.

Consider that we would exit the SPY trade if SPY rose to 300, about 2.5%. With some effort, we could use trailing stops on the position with the expectation of hitting at least a 5% sell-off from 303 or a target of 287, another 2% from the last close. Very low, 0.8:1 Reward:Risk. We would rather see 2-4:1.

Pushing it, considering a 7.5% selloff we would see another 4.5% from the last close. This yields a 1.8:1 Reward:Risk. Better, less likely, yet this would put us at about 2794, a very strong support level from December and February peaks.

AMZN

Selling 100 shares of AMZN would lock up about $182,000. There are not many support levels for Amazon right now, the nearest being a fairly weak one at 1760, about 13% below the latest close. 1700 is much stronger. Either is is further than we would like but still makes for a good example.

Options

SPY

When aiming to profit from a selloff using Puts, we prefer to buy short term and just out of the money. This is much different from the tactic of long dated Calls.

In this case, the market is 5 days into the correction and may be more than half way done with it. There is no real science to choosing yet we would like sufficient time for the trade to work, so we will use the 16 August strikes. Looking at the Ask prices, there is a minor point of inflection at the 289 strike making the 288 appear more expensive. We will use the 289.

Stop loss on options is generally set at 50% of the cost. This depends wholly on the buyer's risk tolerance. We use 50%.

Establishing a target price is done through calculations available from your broker's platform. Our desire is to be out of the trade in less than a week as the time decay is more severe in the final week. As we did with shorting the SPY, the target there is between 279 and 287; this yields the option target prices shown in the table under the assumption Volatility remains unchanged.

As you can see, the time decay overwhelms the option intrinsic value change if we only see a move to 287 for SPY, resulting in a loss. Another 10 points, however, and we receive a small reward.

As is always the case, Options are more risky than stock plays. We risk less money so make less yet the risks are higher because the profit must happen prior to expiration.

AMZN

Similarly for AMZN, choose the 16 August 1822.5 strike Put. Results are shown below and are similar to the SPY Put results at 0.4:1, not really awe-inspiring.

Bear Call Spreads

One element to consider on low yield spreads like these is that you have to do a lot of them to make the trade worthwhile. It is not unusual to do 100-200 contracts for each element. If a broker charges $4.95 per ticket and $0.75 per contract, the round trip cost of this position in commissions could be $300-600. Clearly not insignificant. Depending on your trading frequency, you can negotiate both numbers down, most significantly the per contract number could be less than 1/3 the advertised number.

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Credit spreads are seductive little trades because you take in money up front and the Reward:Risk is vary appealing. Over time, the probability is that the trader will lose significantly more than what is taken in. It is very important to have a strong commitment to the future trend before entering these.

SPY

We generally look for about a 30 Delta Call to sell and buy the next higher strike, again looking short term out to 16 Aug. In this case, that means the 16 Aug 297/297.5 Bear Call Spread, receiving $20 in credit per contract. Given those numbers, we would likely buy 250 for an exposure of $5,000.

Credit spreads are a bit different from other verticals. We generally exit the trade at 60% profit or above and stop out at 50% loss.

The results are in the table below.

AMZN

Using the same plan for AMZN, the 16 Aug 1875/1877.5 Bear Call Spread works, giving us $77 in credit. Results are below.

Volatility Trades

A very different way to go is to use a trade on Volatility. This is a market trade using VXX as the proxy for future market Volatility. We covered some of the details of this instrument in our hedge series starting with Volatility Hedge.

Much like the SPY and AMZN examples above, shorting VXX or Buying Calls (VXX moves opposite the S&P so Calls rather than Puts) does not provide enough leverage or are too costly.

A vertical, however, is potentially perfect while keeping in mind the additional commission cost.

With the same rules as before, we want to sell a Bull Put Spread, something like the 16 Aug 27/27.5 Put credit spread, giving us $37 per contract. Results are below.

Action