I normally don’t put much stock, so to speak, in technical analysis. I use it as a windsock as opposed to a crystal ball. However, in bear markets, it can become very useful because it can show when the market is likely to be overbought.
Right now, that appears to be the case. There’s a lot of overhead resistance the market can’t break through, and that suggests the market’s path of least resistance is down.
If you’re concerned — and you probably should be — you can use puts and calls to help hedge your portfolio. Of course, the best defense is a long-term diversified portfolio, but sometimes a hedge using puts and calls can be an excellent strategy (as long as it fits with your risk tolerance).
A great idea is to take an index fund or two that you own and sell covered calls against it. The market is unlikely to move much higher from here, so even if your index ETF gets called away, you can always buy it back and not have lost much upside in the process.
Here are a few trades I like right now.
Puts and Calls on the SPDR S&P 500 ETF Trust (SPY)
Take something simple like the SPDR S&P 500 ETF (SPY), which many investors may have in their portfolios, but may never have considered using puts and calls with.
In this case, the SPY closed Wednesday at $199.38. You can sell the May $200 covered calls for $5.22. You get a very nice 2.6% downside hedge that may slightly ease the burden of a market drop.
Or, you could bet on the actual decline itself by purchasing the Apr $200 puts for $4.78. In this case, if the SPY falls below $195.22 on or before April 15, you make money. So you’ll suffer the same 2.5% loss as everyone else, but if the market really tanks, you’ll offset those losses.
Puts and Calls on the iShares Russell 2000 Index (ETF) (IWM)
You can consider the same strategies with the iShares Russell 2000 ETF (IWM). Small-cap stocks have a tendency to be more volatile, and also tend to move very quickly in certain market conditions. The IWM is a common holding for many investors because it’s a broadly diversified index.
The IWM closed Wednesday at $106.80. Now, it appears that the IWM actually has more potential upside before hitting resistance. You could choose to sell a call that’s further out of the money at a later date to keep from having it called away. The Jun 17 $108 calls are selling for $3.63. So you get about a 3.4% downside hedge.
On the down side, you could buy the Apr $106 puts for only $2.78. That means if the IWM falls below $104.02 — which I think is very likely — you’ll start making money to offset other losses. You don’t even have to hold IWM to buy the protection to offset losses elsewhere.
Puts and Calls on the PowerShares QQQ Trust, Series 1 (ETF) (QQQ)
The most volatile of all of these three, when it comes to puts and calls, is the PowerShares QQQ Trust (QQQ), which tracks the Nasdaq-100. This closed Wednesday at $104.82, and it could move in either direction.
I think here you should consider selling the June $105 covered calls for $4.18. You get about a 4% hedge, which is pretty significant, and a long time for that index to move.
You could also buy puts in conjunction with selling covered calls (as you can with any of these puts and calls combinations). Many times, traders will sell the calls and use the proceeds to finance purchase of puts.
The Apr 15 $105 puts are selling for $2.85. You could purchase these and already be in the money, so if the QQQ falls below $102.15, you’ll break even and start making money, or offsetting other losses.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance. He has 20 years’ experience in the stock market, and has written more than 1,200 articles on investing. He also is the Manager of the forthcoming Liberty Portfolio. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com. As of this writing, he was long RWM, SH and PSQ — short plays on the IWM, SH and QQQ.