At Stutland Volatility Group, we believe that a significant near-term risk to U.S. equities is an appreciation in the dollar against the euro, the latter of which hit a two-month low against the U.S. dollar yesterday.
Typically, when the dollar strengthens, stocks sell off. The inverse relationship between the U.S. dollar and the stock market exists because of the carry trade. In particular, low interest rates in the U.S. prompt global traders to short the dollar and buy higher-yielding assets on a highly levered basis.
Should news out of Europe fail to reassure investors that the debt crisis is being resolved, we expect the carry trade to be quickly unwound as traders sell stocks and buy back dollars.
To protect a long stock, short option portfolio from this scenario, we recommend buying a CurrencyShares Euro Trust (NYSE:FXE) January 130-135 put spread.
This trade turns a profit if the dollar appreciates against the euro, causing FXE to settle below $132.90 at January expiration.
If FXE closes below the long $130 strike, the trade returns $2.90. If FXE instead moves up, losses are capped at $2.10.
Keep in mind, it doesn’t matter exactly what you pay or collect for each individual leg of the trade, as long as you enter the spread for approximately $2.10 to keep the risk/reward ratio intact, which is outlined below.
Stock Price: $133.20
Option Play: Bear Put-Spread
Buy: January 135 Put @ $3.60
Sell: January 130 Put @ $1.50
Net Cost: $2.10 = $3.60 – $1.50 (Long Put – Short Put)
Breakeven: $132.90 = $135.00 – $2.10 (Long Put – Net Cost)
Max Profit: $2.90 = ($135 – $130) – $2.10 (Spread Width – Net Cost)
Max Loss: $2.10 (Net Cost)