The stock market is always right on price, but it has a horrible sense of timing. With many investors afraid that the recent strength in the stock market could be the mother of all bear traps, that truth is worth pondering.
Stocks have rallied higher since mid-June, but the threatening hobgoblins haven’t vanished. The Federal Reserve and other central banks are still raising interest rates to battle inflation, which is proving to be as pernicious and widespread as the coronavirus. Corporate earnings, which are critical to stock prices, have been reasonably good so far this earnings season, but analysts are widely expected to lower their estimates in the future in anticipation of tougher times.
The S&P 500 index has advanced some 15% since mid-June. Portfolios that had been banged up in 2022 got bailed out just as it seemed the stock market was headed sharply lower.
Bull markets climb a wall of worry, and consumer spending, which is the engine of the U.S. economy, has so far held up reasonably well. Still, many institutional investors have been hedging their portfolios with put options in anticipation of challenges ahead. (Puts increase in value when stock prices decline.)
Rather than getting lost in a high-minded debate about what may happen to the stock market, or acting as if the market has bottomed, many investors would do well to focus on their own holdings and risk tolerance—and consider how much their stock portfolio figures into their lives.
If you want to insulate your portfolio from some of the stock market’s gyrations, a put-spread collar—buying a put option and selling another put with the same expiration but a lower strike price, as well as selling a call option—is an economical way to hedge. We discussed this strategy last week as a way to profit from a decline in consumer spending. In response, readers asked how the strategy could be applied to a portfolio of S&P 500 stocks.
With the SPDR S&P 500 exchange-traded fund (ticker: SPY) at $414, investors could consider buying the January $375 put and selling the January $335 put, as well as selling the January $460 call.
The put-spread collar increases in value if the ETF declines to $335. The call sale offsets the cost of the put spread, but if the ETF rallies—say, because the Fed’s rate-hiking doesn’t push the economy into a recession or worse—the call will increase in value. In that event, investors will regret selling it to finance the trade.
The strategy generates a credit of about $1.10. The hedge is worth a maximum of $41.10 if the ETF is at $335 at expiration. During the past 52 weeks, it has ranged from $362.17 to $479.98.
The January expiration date covers another earnings season, three meetings of the Fed’s rate-setting committee, the midterm Congressional elections, and various economic reports that are critical to determining whether the U.S. economy is down and out or if the worst is over.
Put-spread collars are often attractive because they can make hedging, which is usually expensive, less expensive. At the same time, the strategy creates a defined pathway around a stock portfolio that limits both losses and gains.
It is largely for that reason that the strategy is highly valued by many investors, especially those who are at a time in life when they need to be invested in equities for the potential higher returns but might not have time to recover from serious losses.
Steven M. Sears is the president and chief operating officer of Options Solutions, a specialized asset-management firm. Neither he nor the firm has a position in the options or underlying securities mentioned in this column.