The S&P 500 is currently at a three month high, and has appreciated almost 10% since going below the 1,175 mark in late November. Many investors (myself included) feel that the underlying fundamentals haven’t really changed. To be very brief, Europe is still in a crisis, debt is still weighing down balance sheets, and unemployment is still too high. In other words, until conditions substantially improve, whatever goes up must come down. Based on this premise, I’m betting that the S&P 500 will fall back down to 1,250 (about a 3% drop).
I’ve created a short-term investment strategy that will allow me profit in these conditions by buying UltraShort S&P500 (SDS), and hedging my position by buying Short S&P 500 (SH) Put Options. SDS is a fund that is twice the inverse of the daily performance of the S&P 500, while SH is a fund that is exactly inverse to the daily performance of the S&P 500.
I’ve created a model that assumes the 3% drop in the S&P 500 to 1,250. Since we cannot truly predict which direction the market moves, I’ve also assumed a scenario where I’m wrong, and the S&P 500 appreciates by 3%. I’ve used the following put option for SD:
I’ve taken a $10,000 long position in SDS (essentially shorting the market 2X) and I’ve taken a .88% hedge in SD put options, for a total investment cash outlay of $10,088. If my bet is correct and the S&P 500 falls 3%, I’ve made a 5% return:
| 3% Decrease to S&P 500 | ||
| Scenario 1: S&P 500 3% Decrease | % Return | |
| SDS Gain | $ 600 | |
| SH Put Option Gain | $ - | |
| SH Put Option premium | $ (88) | |
| Total Gain | $ 512 | 5.08% |
If I am incorrect, and the S&P 500 appreciates 3%, I am completely hedged:
| 3% Increase to S&P 500 | ||
| Scenario 2: S&P 3% Increase | % Return | |
| SDS Loss | $ (600) | |
| SH Put Option Gain | $ 690 | |
| SH Put Option premium | $ (88) | |
| Total Gain | $ 2 | 0.02% |
I’ve also assumed different scenarios where the S&P 500 increases or decreases anywhere between 1-5%. Returns ranged anywhere from -0.5% to 9%, further demonstrating that the hedged SD Put Option minimizes losses even with significant market gains.
Conclusion
If you believe the S&P 500 is overvalued, this short-term investment strategy is highly effective at maximizing returns while mitigating losses through hedged Put Options.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
