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I am (and have been since the end of May) bearish on the global economy. I believe that corporate margins will collapse, earnings will disappoint, and a global recession (if not depression) will kick in due to the debt crisis in Europe. Many would agree that a Greek default is a question of when, not if.

For those with a lot of capital and knowledge of options, I would recommend the following. I do not want to debate the state of the economy (read my other posts such as “Stocks Are Not Cheap: More Likely to go Down Than Up”). Here’s my idea.

Sell puts on safe haven or strong blue chips like Apple (NASDAQ:AAPL), Coca Cola (NYSE:KO), Procter & Gamble (NYSE:PG), Johnson & Johnson (NYSE:JNJ), etc. Aggregate your deltas and short the SPY, making your position delta neutral to hedge against the put position you have created and rebalance the position once a week. Sell puts that are far out of the money and a few months from expiration (maybe the AAPL DEC 275 or 250 for example). The bet is that the recent spike in demand for puts has driven up their price so that the implied volatility of the puts you will be selling will be higher than their future volatility, giving you an edge.

In addition, you are betting that the SPY will fall harder than those defensive blue chip stocks (this is the most important part) and that the puts that you sold are so far out of the money that these defensive stocks will not drop that far over the next few months.

By rebalancing, you do have a little bit of exposure to the spread between the rate at which the market falls and the blue chips while trying to capture that difference in iVol and future volatility (selling puts trading rich in terms of iVol, we are hoping that iVol collapses as fast as possible). Essentially, you are giving yourself better odds by rebalancing as you are putting on more individual bets over time that are stacked in your favor while controlling risk. (The biggest concern is transaction costs, but anyone with a Think or Swim account can short or buy back the SPY for $5 a trade to stay delta neutral).

I am very bearish on the market. However, I believe that the market will fall harder than a KO or JNJ and AAPL will have sales strong enough Q3 to keep it above $250. Also, you are hedging by shorting the SPY while doing this. It may turn out that future volatility goes even higher if we have another 2008 collapse.

This is just an idea and has risk like any other option play. Look into it and make sure you have the same outlook on future volatility as I do as well as outlook on the market. Look at historical volatility over 2008 (for example) for guidance and compare volatility from various time periods (preferably volatile ones comparable to today's environment) to implied volatility today.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Bearish On The Market - Time For A Delta Neutral Hedge