With the S&P 500 Index still near recent new highs and with noteworthy earnings reports due this week, perhaps adding some hedges just in case makes sense. Since the broad category of Hedging Strategies covers more ground than available space here, we focus on using SPDR S&P 500 ETF (SPY) put spreads to hedge overall equity market risk. First, our regular Market Review.

S&P 500 Index (SPX) 2976.61 declined 37.16 points or -1.23% last week after making new closing and intraday highs last Monday. With the first support area on any pullback at 2950, the 50-day moving average crosses way down at 2899.69 and would represent a significant pullback.

CBOE Volatility Index® (VIX) 14.45 advanced 2.06 points or +16.63% last week. Our similar IVolatility Implied Volatility Index Mean, IVXM using four at-the-money options for each expiration period along with our proprietary technique that includes the delta and vega of each option, gained 1.52 points or +15.26% to 11.48. The IVXM and SPX charts follow.

As an indication of increased put activity before earnings reports this week, here is a chart showing the SPX put/call ratio at 2.7, the highest in 6 months. Although typically considered a contrary indicator at the extremes, it could quickly decline by the end of the week if there are few negative earnings surprises.

VIX Futures Premium

The chart below shows as our calculation of Larry McMillan’s day-weighted average between the first and second-month futures contracts.

With 22 trading days until August expiration, the day-weighted premium between August and September allocated 88% to August and 12% to September for a 10.70% premium, just into the bullish green zone, vs. 20.93% premium for the week ending July 12.

The premium measures the amount that futures currently trade above or below the cash VIX, (contango or backwardation) until front month futures contract converges with the VIX at expiration on August 21, 2019.

For daily updates, follow our end-of-day volume weighted premium version located about halfway down the home page in the Options Data Analysis section on our website.

Hedging Long Equity Positions

SPDR S&P 500 ETF (SPY) 297.17 declined 3.48 points or -1.16% for the week.

SPY makes a good underlying for hedging strategies with many strike prices available, all with good volume and narrow bid/ask spreads.

The option details as of Friday follow.

With a current Historical Volatility of 8.32 and 6.84 using the Parkinson's range method, the Implied Volatility Index Mean is 11.99 at .17 of its 52-week range. The implied volatility/historical volatility ratio using the range method is 1.75, so option prices are somewhat expensive relative the recent movement of the ETF.

Friday’s option volume was 3.0 million contracts with the 5-day average of 2.2 million, with narrow bid/ask spreads, many just .01 wide.

Time to expiration is one of the first things to consider. Since SPY has weekly options, a put spread could last just this week during earnings reporting. Assuming expectations have been lowered as usual before reporting and hold up better than expected then a short- term put spread could be good enough. While a shorter-term weekly spread will cost less, it will also expire on Friday when the entire premium paid could be gone.

Perhaps some companies will report better than expected earnings while others are as expected or lower, making the overall results inconclusive. If so, consider a spread with more time to expiration. Typically, initial time estimates have a tendency to be too short. Better strategies allow more time.

For example, with an objective to hedge a market decline due to earnings disappointments for the next three weeks, consider options that expire August 16.

Here is an example using at-the-money puts.

Advanced Options shows the long put has a delta, (rate of change in the option price relative to small change in the price of SPY) of -.4826 with a short put delta of .3114 (short negative delta makes it positive) so the spread delta becomes -.1712 and the objective is to have a short delta spread. Using the ask price for the buy and mid for the sell the debit or cost would be 1.44 at 29% of the width of the spread with a slight implied volatility edge, meaning the put sold is relatively more expensive in implied volatility terms than the long put. In addition, having a limited and defined cost, both time decay and changes in implied volatility are partially hedged as well. If earnings reports are generally better than expected this week, use a close back above the previous high July 15 high at 301.13 as the SU (stop/unwind).

Next, an example based upon only needing hedge protection in the event SPY declines below support at 295. Using out-of-the-money puts reduces the cost, but lowers the initial delta protection.

The long put has a delta of -.3114 with a short put delta of .2012, so the spread delta becomes -.1102. Again, using the ask price for the buy and mid for the sell the debit or cost would be .84 at 17% of the width of the spread with about the same implied volatility edge. Just in case, as with the first spread, use a close back above the previous high July 15 high at 301.13 as the SU (stop/unwind).

One more example, this one, also using out-of-the-money puts, allows more time for more earnings reports to be analyzed and downgrades issued, assuming most are lower than expected.

The long put has a delta of -.3678 with a short put delta of .2803, so the spread delta becomes -.0875. Again, using the ask price for the buy and mid for the sell the debit or cost would be 1.17 at 23% of the width of the spread with slightly less implied volatility edge. For a little more cost, the time to expiration more than doubles. Just in case, as with the spreads above, use a close back above the previous high July 15 high at 301.13 as the SU (stop/unwind).

The put spread suggestions above are based on the ask price for the buy and middle price for the sell presuming some price improvement is possible. Monday’s option prices will be somewhat different due to the time decay over the weekend and any underlying price change.

Strategy

As the put spreads above explain, the objective is to hedge against disappointing earnings reports for the next few weeks. Keep in mind the earnings report game lowers expectations before reporting begins so they can be beaten and push stock prices higher. The risk is lowered expectations may also disappoint and the market goes lower. However, since the major indexes were at new highs just as reporting began; this quarter reporting could be an opportunity to "sell the news."

While the hedging record shows mostly losses, consider Hedging Strategies like insurance policies that cost money and never used, so minimize their cost as much as possible for an optimal level of protection.

Summary

Although the major indexes made new highs early last week and then retreated slightly causing options implied to increase, the S&P 500 Index remains well above the first support level, although there signs of increased hedging activity since SPX put volume increased. With important earnings reports due this week, put spreads will help hedge any potential downside risk if the consensus concludes 2Q earnings were weaker than expected.