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This morning, I am recommending a bearish trade on SPDR S&P 500 ETF (NYSEARCA:SPY).
I mentioned last Friday (and again on Monday) that my indicators are giving sell signals. At the start of this week, the market finally started pulling back, possibly due to renewed fear surrounding U.S.-China trade negotiations.
I’ve been expecting the market to pull back from its recent highs for a while, and now that it’s happened, I think we need to put on some downside insurance in the form of a ratio put credit spread on SPY.
A Jump in Volatility
SPY is an ETF that tries to mimic the performance of the S&P 500, which is why I like to use it for downside insurance. As the market pulls back, we can collect a profit without having to take a position on a specific stock.
And since one of my favorite indicators — the S&P 500 Volatility Index — is telling us that caution is warranted right now, I think downside insurance is the right move.
Daily Chart of S&P 500 Volatility Index (VIX) — Chart Source: TradingView
As you can see above, the VIX jumped sharply this week and closed above the 20 level on Tuesday. This is the first time the VIX has cleared its 200-day moving average since late March, which means it’s time to start getting more defensive again.
Could SPY Head Below its 50-Day Moving Average?
If we turn to SPY’s daily chart, we see it has been dropping since last week. The stock was able to stay above its 50-day moving average (MA). If that 50-day MA holds as support, SPY may recover. If not, it could retest its 200-day MA.
Daily Chart of SPDR S&P 500 ETF (SPY) — Chart Source: TradingView
The key with downside insurance is making sure it is cheap, because you don’t want to have too much at risk if the market doesn’t head lower. With a ratio put credit spread, you can get paid to take this position, which is why I’m recommending the following trade:
Using a spread order, buy to open 1 SPY May 31st $285 put and sell to open 2 SPY May 31st $276 puts for a net credit of about $0.05.
Note: There are several May expirations available for SPY options. Be sure you are opening the weekly options that expire on Friday, May 31, 2019.
About Ratio Put Credit Spreads
This ratio put credit spread is a bearish position. It involves writing (selling to open) two options and simultaneously purchasing (buying to open) an option at a different strike price in the same underlying security. The position, or leg, of the spread trade that you sell gives you a cash credit to your trading account.
That credit is the income we collect up front. Even if SPY doesn’t drop we get to keep that premium.
This is similar to a ratio debit spread, which is a way to lower the cost of buying options, as the two options that you sell to open (short) help offset the cost of the option that you buy to open.
Therefore, this ratio put credit spread is a way to earn a small profit while still establishing a bearish put option trade. Many brokers will require the use of margin and/or a set amount of reserved capital and/or a margin account to execute a ratio spread; contact your broker directly for specific requirements.
I mentioned above that we could take profits as the stock declines. That’s because unlike a regular put credit spread, the two short options in this trade will lose value to time decay faster than the one long option.
Eventually, that could widen the spread between our long and short options, letting us buy back the short options at a lower price. If the long option loses less value over time, we can sell it back and collect a profit. If SPY loses value, it may help widen the spread faster.
Because you are short a naked put in this ratio put credit spread, the risk is that you could be obligated to buy 100 shares of SPY at the $276 strike price for every 1 contract that you are short of the SPY May 31st $276 puts. So, this is inherently a higher risk play.
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Ken Trester is editor of the popular Maximum Options program. Trester has been trading options since the first exchanges opened in 1973 with a winning streak that goes back to 1984 with money-doubling average annual profits since 1990.