Initiated SPY vertical put debit spread
Bought 10 contracts of SPY $198.00 puts expiring 11/18 for $2.52 and sold 20 contracts of SPY $180.00 puts expiring 11/18 for $1.06. Total debit after commission was $438.40, or 44¢/share (per share debits and credits always reflect the contract count of the more expensive leg.)
I had mentioned previously, that I would be looking to reduce the drag created by my hedges. Compared to previous hedges, this one is very, very cheap. But it has two central weaknesses:
- If the stock market would suddenly fall out of bed, SPY implied volatility (i.e. VIX) would almost certainly spike higher. This combination, lower price of SPY, and higher volatility, if it came soon (with ample time before expiration), would cause the short leg of the spread to pick up a lot of delta and vega. It would become more valuable than the long leg and the position could not be unwound at a profit until close to expiration.
- More importantly, given that the short leg has twice as many contracts as the long leg. there’s a maximum market drop beyond which, this spread will not just fail to be protective, but actually become very costly.
These are severe limitations, to be sure. But I feel justified in taking this risk: First, in order to push this position into a significant loss position at expiration, SPY would need to sit below the lower break-even price of $162.43 at expiration. The likelihood of such a 25% drop happening by 11/18 is about 1.5%. A more moderate drop that would bring the position into a profit position would need to see the SPY fall below it’s upper break-even point of 197.57. This has a probability of 7.6% — still remote, but not out of the question. And this is the exact scenario that I am looking to guard against.
I am not sure that this will be the model for all my future hedging. But I will give this a try for now. Ideally, such a ratio put spread should probably be used with a shorter time to maturity to minimize the potential for the short leg to gain much value, following a swift market drop of 10%, say. But in this case, the risk I am most concerned about is a global trade war leading to a global recession in a Trump presidency. That risk won’t even really start to impact the market until September or October, unless by that time the polls indicate that the race is lost for the Donald.