Another Opportunity In A Market Correction

Includes: SDS, SPY
by: Joseph Meth

Some of us have been fully invested since early in this bull market. We like our stocks (however we're not married to them, it should be added) and don't feel like swapping any of them out for a laggard stock or late bloomer, so we don't need another article about why one stock or another has some excellent prospects for advancing sometime in the future. But we see pressure on our portfolio as the market appears to be struggling to maintain its upward momentum in the face of "taper talk" and "Turkey turbulence."

Many excellent articles outlining suggestions for ways to hedge are here on Seeking Alpha. A list of past articles include:

Should we change our longer-term, generally bullish view and begin taking some risk off by liquidating some of our excellent positions and increasing our cash position? Should we attempt to hedge all or a portion of the portfolio by one of the many available hedging strategies? Or should we just turn our usually bullish outlook around and place a speculative, opportunistic and profitable bet that the market just might be experiencing a short, relatively small correction? Here are only some of the top results in the search and the list could actually run for pages.

Personally, I believe that a "hedge" is equivalent to taking a short position for lower market prices. So in the current economic and market environment, I decided to take a small but highly leveraged short-term position, which should generate an extremely nice percentage return with a small decline in the S&P 500 Index:

  • The underlying security is SDS, the 2x short S&P 500 Index ETF. Theoretically, the percentage move in SDS should approximately equal inversely three times the percentage move of SPY. If, for example, SPY declines by 5% over the next couple of weeks, SDS should increase by 10%.
  • Call options on SDS are available, which add additional leverage to the transaction. I was looking for the correction to take place sometime in the Second Half so I selected at the money put options expiring in December. The cost of those 40 strike price options at the time were $3.50, SDS was selling at 39.50 so the premium cost was about 10%, or (40+3.50)/39.50 = 110.12.
  • Since these are American-style options, they can be exercised or sold at any time. Whenever the market actually does decline (as it has since I completed the transaction), the options can be sold at a profit. Alternatively, the option position can be closed out at a controlled and limited loss if the market increases instead.

Because this is an highly leveraged trade, it is extremely volatile. In fact, one of the most significant factors in option pricing is the implied future volatility (IV) of the underlying security. Since making the trade yesterday, it has generated over a 20% return, some of which comes from a near doubling of the IV implicit in the option's pricing.

Conclusion: This is not a trade for everyone. Should you decide to try your hand "hedging" or taking a short-term bet that the market will correct in this or a similar tactic then it should be for a very small percentage of your capital. For it to be successful, you need to remember that

  1. "timing is everything,"
  2. highly leveraged transactions cut both ways and
  3. this is the antithesis of a buy-and-hold investment strategy.

Disclosure: I am long SDS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.