Using a ‘bear put spread’ to hedge against further market declines

I’ll review some of the reasons why the stock market is getting hit and update a hedge trade I use during market turbulence. On July 1st, I recommended hedging a “most unusual” election year. It’s gotten a lot more unusual since then, and that hedge is paying off — hugely. The S & P 500 5,350 puts I discussed are trading nearly $170 as I write this, up ~ $12,000 per contract. This is even though the S & P 500 is down only 2.3% since I wrote that article over a month ago. .SPX YTD mountain S & P 500, ytd Let’s look at reasons for selloff: Economic data, such as last week’s employment data which was worse than expected and included negative revisions, signals that recession may already be upon us. McDonald’s earnings confirmed what Starbucks told us months ago. Consumers are hurting if rising delinquencies, falling savings, and surveys weren’t enough evidence even before those results. Not to be overlooked is the political situation. Since President Joe Biden stepped down and the Democrats elevated the once-unpopular Kamala Harris as the party’s pick, Harris’s poll numbers have improved significantly. This may be good for Democrats, but it’s not great for stocks. Cryptocurrencies were also buoyed by Trump’s improvements in polls post-debate and post-assassination as he enthusiastically embraced them. These things and other reasons have led to a sharp spike in implied volatility, the price traders pay for options. The VIX Index , a measure of 30-day implied volatility on the S & P 500 Index, has more than doubled since July 15th, two days after the Trump assassination attempt. The trade This brings me to what I am doing now, which is rolling down the puts I proposed earlier in this column to a put spread. A put spread cannot completely make up for the higher premiums we now see, but it can mitigate it significantly. For example, the S & P 500 August 30th 5350 puts I recommended for $50 can now be sold for nearly $170 (and possibly higher by the time you read this). One could roll those options down and out to the September 5200/4500 S & P 500 put spread which costs about $100. This would recover all of the $50 in premium spent and also bank $20 in profits while still offering some downside exposure/protection down to $4500, more than another 15% over the next seven-plus weeks. A put spread, specifically a bear put spread, is an options trading strategy that involves buying and selling put options on the same underlying asset with the same expiration date but different strike prices. The goal of this strategy is to profit from a decline in the price of the underlying asset. If you didn’t read the earlier article, here are the components of a long put spread, sometimes referred to as a “Bear Put Spread.” Long Put Option: Buy a put option with a higher strike price, for example the September expiration SPX 5000 strike puts or the SPY 500 puts – both are proxies for the S & P 500. Short Put Option: Sell a put option with a lower strike price such as the September S & P 4500 or SPY 450 puts . How it works: If the price of the underlying asset falls, the value of the long put option increases, while the value of the short put option also increases but to a lesser extent. The maximum profit is achieved when the price of the underlying asset falls to or below the lower strike price. The maximum loss is limited to the net premium paid for the spread. In periods of high implied volatility, option premiums are generally higher because the market anticipates larger price movements. By selling a put option (short put) in a high volatility environment, the trader receives a higher premium, which helps offset the higher cost of the long put option. High implied volatility often means that there is a greater chance of significant price movements. A substantial decline in the price of the underlying asset increases the potential for the long put option to become deeply in-the-money, maximizing the profit potential of the bear put spread. While high implied volatility can increase the cost of buying options, the bear put spread strategy inherently limits the maximum loss to the net premium paid. This makes it a more attractive strategy in volatile markets compared to simply buying a put option outright, where the potential loss is the entire premium paid for the long put option. DISCLOSURES: (None) All opinions expressed by the CNBC Pro contributors are solely their opinions and do not reflect the opinions of CNBC, NBC UNIVERSAL, their parent company or affiliates, and may have been previously disseminated by them on television, radio, internet or another medium. THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.