With the stock market up and volatility still relatively low, now could be a good time for an investor to establish some insurance or hedges against a market pullback. One option position that could be established to meet this objective is buying the October $71 puts and selling the October $69 puts in the PowerShares QQQ Trust ETF (NASDAQ:QQQ). Currently, the QQQ is trading at around $70.25 and this trade costs $0.92/contract to establish.
If held to expiration, the trade will either lose $92/contract or make $108/contract. That's a little better than 50/50 odds that the market will be lower at option expiration. The breakeven point of the trade is $70.08, or a whopping 0.24% below the trade price at the time of entry.
If not held to expiration, pure option theory says there is approximately a 67% chance of the ETF touching the low-end $69 strike at some point before expiration. That means at some point in the life of this trade there is a 67% chance this position will show a profit, and offer the opportunity for an investor to harvest some profits from the trade prior to expiration. If an investor believes reversion to the mean can have a real influence on price, then after the recent run-up the odds of a dip back to $69 may even be higher than 67%. No matter what the exact odds of the ETF touching $69 are, it seems this trade with 50/50 odds has about a 2-in-3 chance of showing a profit at some point over the next month. Those seem like good odds.
From a hedging perspective, if this trade ends up being a loss, it is very likely that the rest of an investor's long-oriented portfolio will be up over this period of time. An investor can vary the number of contracts bought in this trade based on how much insurance he or she wants to have against a short-term market pullback.
When using index products it is often helpful to be aware of the components of the index, which can have a big influence on the index. Apple (NASDAQ:AAPL) is by far the largest holding of the QQQ (19% weighting). So to help make this trade a winner, it would be helpful for Apple to stall or fall from its current price of around $700. Betting against Apple is certainly very contrarian and controversial. However, hedging by its very nature is contrarian. Once deciding to hedge, using options on the QQQ as an investing vehicle is a cheaper way to implement the strategy than betting directly against Apple via its options. Furthermore, there are many other old technology companies with significant weighting in the QQQ. That means this position, while influenced by Apple, is not just a direct bet against it.
This trade seems to provide some protection for a portfolio, to have a good probability of success, and to require only a small amount of capital. More importantly, it is just one example of a type of options trade that can be established to provide some amount of hedge for an overall portfolio.
Disclosure: I am short QQQ. 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.
Disclaimer: This posting is for informational, educational and entertainment purposes only and should not be considered investment advice.