Stocks are soaring across the board this morning in response to news that former Treasury Secretary Larry Summers has dropped out of the running to become the next Federal Reserve chairman. The S&P 500, Dow Jones Industrial Average and Russell 2000 all gapped higher some 1% to kick-off the new trading week.
Given the integral role the Fed and Bernanke have played in the ongoing bull market, the Street is becoming obsessed with any developments regarding his eventual successor.
The “Summers rally” might well be providing a gift to nervous Nellies seeking protection ahead of this week’s much anticipated Fed meeting, during which Bernanke & Co. are widely expected to begin to taper their asset purchases. Optimists would like to think that the forward-looking market has already fully discounted the upcoming taper, but a volatility-inducing surprise could still be in store.
Summers’ gift is really simple: It’s an opportunity to acquire portfolio protection with the market at higher prices.
With today’s jump into record territory for the S&P 500, the premier large-cap index is up 5% from its August low. The rapid recovery has been a bullish rout interrupted by a mere two down days. With the latest upswing having already traveled so far, taking profits or acquiring protection into today’s gap might not be a bad idea.
When it comes to using the options market for protection, traders can truly hand-craft every aspect of their purchase. Depending on which strategy, strike price and expiration is used, the duration, cost and magnitude of insurance can be customized to fit your need.
If you’re seeking cheap, short-term protection to minimize any volatility following this week’s Fed meeting, you could add a September bear put spread on the SPDR S&P 500 ETF (SPY) to your portfolio to hedge your downside exposure. The spread presents a cheaper alternative to simply buying put options outright.
Click to Enlarge For example, with the SPY trading around $171 you could buy the Sep 171-168 put spread by purchasing the Sep 171 put and selling the 168 put for $1.20. The max risk is limited to the initial $120 paid, and the max reward is limited to $180.
As long as the SPY doesn’t decline more than 2% this week (i.e., it remains above $168), the put spread will provide more cost-effective protection than had you simply purchased the 171 strike put.
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.