Back in May of 1916, the British participated in what is arguably one of the most self-serving, globally damaging geopolitical jiggerings of the last century when British diplomat Mark Sykes partnered with his French counterpart, François Georges-Picot, to partition the Middle Eastern remnants of the Ottoman Empire along lines that arrogantly disregarded cultural, ethnic and religious sensibilities to, instead, serve the desires of Britain. The result helped give rise to the terror-plagued world we have today.
Next week, the Brits have a chance to screw the world once again.
On Thursday, Brits will vote to stay in or to exit the European Union — the so-called Brexit decision.
Stay (the smart decision) and life goes on as usual.
Exit (a catastrophic decision) and British voters will wreak havoc on global markets because, despite the self-absorbed logic of the “Leave” camp, the impacts of the vote aren’t neatly contained in Britain.
For that reason, I am recommending a short-term insurance trade to place now as a way to protect your portfolio against potential British disaster.
First, let me explain why a vote to leave is more than just a British issue.
Britain exiting the EU would raise questions about the stability of the EU, which would raise questions about the stability of the euro. Those fears would express themselves as a panicked stampede into the U.S. dollar, which, in turn, would have two direct and negative consequences:
- The U.S. economy would slow even more than it already has because our exporters would suffer from an even stronger dollar that quashes overseas sales and allows foreign goods to compete more effectively against U.S.-made products here at home;
- The Chinese yuan would strengthen, since it’s still strongly tied to the greenback. A stronger yuan would make Chinese-made goods less competitive globally, so the Chinese economy would slow, which would slam the commodity markets, hurting commodity currencies relative to the dollar, thereby strengthening the dollar even more and pinching the U.S. economy even more.
So this Brexit vote is decidedly not a decision contained to the British Isles. It reverberates around the world.
And if Leave carries the day, stocks around the world will tank.
U.S. markets will likely fall by 7% to 10%. European markets will fall more, particularly the U.K.
To protect yourself, you want to own a few put options on the S&P 500.
Here’s the Brexit Strategy
The S&P 500 is currently trading around 2080, give or take. A 7% decline would take that index down to about 1935.
I would “buy to open” SPDR S&P 500 ETF (SPY) put options at the 2060 strike (SPY160715P00206000), giving up the first 1% of a market sell-off, knowing you’ll profit from the rest of any decline that happens. Those options for July expiration cost about $3.25, or $325 per contract, at the moment.
If I’m right and the S&P sells down to 1935 — a 145-point decline — the value of the S&P puts will rise to a minimum of $1,250 per contract (the 125-point difference between the option’s 2060 strike price and the value of the S&P at 1935).
Knowing each contract would be worth $1,250, and that the profit per contract is $925, tells us how many contracts we need for portfolio insurance.
Assume a $100,000 portfolio with $60,000 in stocks. A 7% decline equates to a $4,200 loss. Since each winning contract carries a potential profit of $925, the portfolio needs 4.54 contracts to ensure complete coverage. Options only trade in whole numbers, however, so we’ll round up to five contracts at a total cost of $1,625.
At 1935, those five contracts will be worth, at a minimum, $6,250 (5 x 1250, the intrinsic value between 2060 and 1935), enough to cover the $4,200 loss in market value in the portfolio, as well as the cost of the five options.
In reality, the contracts will be worth more because they expire in July and will have three weeks’ worth of time value remaining.
That time value is important to this strategy for one specific reason: residual value, just in case the Brits show a bit of selfless wisdom and vote to remain part of the EU.
Crucial Insurance in Troubled Times
If Brexit fails, stock markets will rally rather than fall.
As a result, these options will decline in value. But they won’t go to zero because of the three weeks still remaining. In this case, you would sell to close the contracts on June 24 to exit the position, recouping some of your original cost.
What you have effectively done with this strategy is buy short-term insurance against the troubles a Brexit success will unleash, yet assured yourself of reclaiming some of your premium payment if Brexit fails.
I don’t usually recommend trading around geopolitical events, because most of them are fleeting and ultimately meaningless. Brexit is the rare exception. Depending on what the Brits decide, they could once again roil the world.
Until next time, good trading…
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