Seeking Alpha

Everyone Is Greedy, So Let's Hedge The SPY

About: SPDR S&P 500 Trust ETF (SPY)
by: Damon Verial
Damon Verial
Contrarian, newsletter provider, tech, event-driven

The market has shown excessive greed as of a late, and we all know what Buffett says about greed.

The price action of the SPY is complacently bullish but historically rare. This sort of price action tends to occur before a pullback.

Let's hedge conservatively for the pullback. I present a gentle hedge that should be converted to an aggressive hedge if the SPY dips below $300.

I watch the action of the SPDR S&P 500 Trust ETF (SPY) every day. Right now, it is showing unprecedented price action stemming from overnight futures buying. We have seen an excessive amount of greed in the overnight action.

Description: Image result for warren buffett greed quote

(Source: Upload Mega Quotes)

This is especially palpable in the past week. The SPY has gapped up due to overnight buying almost daily:

(Source: E-Trade Pro)

I thought about shorting these gaps, but my backtest show them not to be too reliable. Still, these gaps tend to fill over time, making them playable area gaps, so shorting them isn’t exactly a losing strategy:

(Source: Damon Verial; data from Tiingo)

This type of triple up gap pattern, though, does represent a bearish signal. In my gap-trading experience, I’ve found that multiple gaps of roughly the same size but with average (or below) candlestick size tend to be area gaps. These gap patterns often mark the top of a rally.

Price Action

The current price action is interesting. Via a Markov chain between states “up,” “down,” “white” and “black,” (the first two referring to being up or down at the open, and the last two referring to the candlestick at the end of the day), I’ve found that trading with momentum here is a reliable strategy. Here are the probabilities between states - the visual representation of the Markov chain:

(Source: Damon Verial; data from Tiingo)

Note the feedback between the overnight futures buying and the daily buying:

You could easily stay long the SPY when it’s moving upward and get out once you see either a down gap in the morning or a black candlestick at the end of the day and essentially gain the profits of the rally without being exposed to the downside. This is important, as the downside is really large at present. Valuations are historically high, and the risk of 2019-nCoV further increases both the probability of a correction/crash as well as the magnitude of downward movement once a selloff occurs.

The price action further establishes the downside risk. Although the down->white movement occurs 62% of the time, buying on a down gap is not a smart move. The expected gain (in the statistical sense) of buying down gaps is negative.

Statistical expectation is the sum of P(Xi)*Xi over all i. In short, it is the sum of the products of all the possible movements and the probabilities of those movements. The reason the probability of a down->white movement can be over 50% while the expectation of buying on a down gap being negative lies in the magnitude: Red candlesticks are much larger than green candlesticks.

Thus, on the flip side, shorting with downward movements is a statistically strong strategy. In other words, short when futures are pushing down the SPY or at the end of the day, should you see a red candlestick. As I’m writing this on Friday, the strategy currently means we should be short the SPY, and if not, we should watch the futures for Monday.

The recent price action is by no means normal. To the uninitiated, downward (upward) movements preceding downward (upward) movements sounds like a normal affair. However, this occurs roughly 6% of the time.

The SPY’s returns are usually Gaussian distributed. Here are the SPY’s returns over the current volatility regime (since 2012):

(Source: Damon Verial; data from Tiingo)

It fits well. It is negatively skewed, which makes sense due to the market usually rising. And kurtosis is around 3, which is the standard kurtosis for a Gaussian distribution.

Now check the past three months, during the rally:

(Source: Damon Verial; data from Tiingo)

The negative skew here is even more extreme. The kurtosis is almost half that of the standard Gaussian curve. We’ve seen a rare rally here: small, consistent upward movements.

Slow, Bullish Price Action + Real Economic Threat = Hedging Time

This type of price action typically leads to a correction. This is greed in its statistical form. Greedy markets plus a strong catalyst for a selloff (in today’s case, the pandemic) equals a need for hedging.

In my past article, I presented a hedge that lasted till Jan29. It would have produced a gain. Now, I will present a slightly different hedge:

  1. Buy Feb21 $333 call
  2. Sell Feb21 $330 call

As of Feb7, this strategy will net you a credit of roughly $235 per contract. Opening this strategy implies that you will believe the SPY will fall below $330 before Feb21. The long call saves you from being exposed to unlimited upside risk.

Maximum profit potential is realized when the SPY drops below $330. The idea here is that the SPY’s price action is still bullish, while the risk/reward is in favor of the bears. Being so, this strategy is good for now, but should be switched to a hedge with unlimited downside profit (see my previous article for an example) should the SPY fall below $330.

Risks, and Making It Fit

The long call leg of this strategy already being in the money means that both options will change in value roughly dollar for dollar. This strategy thus has nearly zero risk, making it one of the few strategies that can be considered practical arbitrage. The only catch is that the SPY really does need to fall below $300 for a decent profit; a simple sideways trend or slight pullback won’t net you much profit here.

The near-zero risk of this strategy allows it to fit in any SPY-exposed investor’s profile. If you are buying calls on the SPY, you can also pivot to this strategy to essentially lock in profits. For example, if you are holding calls that are already profitable, you can sell calls of the same expiration date but of lower strike right before a possible market catalyst (e.g., an FOMC meeting).

In this case, the strategy produces a zero-risk downside hedge. For the long-term investor holding the SPY underlying, this option strategy can be performed with far-dated calls, allowing you to reduce the maximum loss suffered should the SPY suddenly pull back. Better yet, this is a positive-vega strategy, meaning that the volatility spike that usually accompanies a pullback will increase the value of your long calls more so than your short calls, improving the chance of profit.

This strategy thus meshes well with investors who disagree with “market timing”: It can be held with negligible decay and without affecting your upside reward. Yet, it dampens the pain your portfolio experiences in the event of a correction or crash. This is not an aggressive hedge, so even SPY bulls need not change their outlook in justifying employing this strategy.

Happy trading and hedging!

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