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Profiting from a Pullback with SPY

Don't just be prepared, profit

The S&P 500 is set to open lower this morning if futures prices are to be believed, and I think a bearish trade on the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) is a good way to protect your portfolio.

My indicators were bullish-to-neutral last Friday, which was a downgrade, and my main concern is the unknown impact of COVID-19, the virus that has been causing problems for almost a month.

In my Hilton Worldwide Holdings Inc. (NYSE:HLT) trade, I mentioned that the company’s CEO said we didn’t know the full extent of the outbreak’s economic impact.

Apple, Inc. (NASDAQ:AAPL) announced it may not meet the performance expectations set in the guidance from last quarter.

COVID-19 is the apparent culprit, so we’re finally starting to see the concrete consequences of this health crisis.

Walmart Reports and Apple Updates

This morning, Walmart, Inc. (NYSE:WMT) reported earnings, and its results for the fourth quarter of 2019 were disappointing, which is leading the market lower.

WMT is an important retail stock, and its poor performance could mean trouble for the sector.

The company missed earnings per share and revenue estimates, and during the holiday season, and it saw weak demand for toys, clothing and video games.

This isn’t exactly surprising — Target Corporation (NYSE:TGT) announced weak toy sales well ahead of its own earnings reports — but WMT also offered weak guidance for 2020.

The company specifically noted that it didn’t expect COVID-19 to impact its performance, but there are two reasons that isn’t comforting.

First, in its earnings report, the company noted that political unrest in Chile, which forced store closures, had an impact on its earnings. That may seem unrelated, but it means that international problems do affect the company’s performance, and it seems logical to assume COVID-19 could affect spending habits in Chinese stores.

Second, AAPL provided an update to its quarterly guidance from January, saying that “worldwide iPhone supply will be temporarily constrained” and that “demand for [their] products within China has been affected.”

AAPL’s announcement is a reminder that this public health crisis will bleed over into the markets. If COVID-19 starts affecting retail stocks like WMT in the near future, it will be a bad sign for the rest of the market. Even if it doesn’t, the effect it is having on a big tech stock like AAPL isn’t reassuring.

Other countries are starting to see more and more cases, and until this situation is resolved, investors need to keep protection in their portfolios.

A Cheap Play on SPY

SPY is an ETF that matches the performance of the S&P 500, and in the chart below, you can see just how well it does that. We aren’t just dealing with issues related to COVID-19. The market has also reached another top, and it could pull back in the short term. SPY is the perfect target for an insurance play.

Daily Chart of S&P 500 and  SPDR S&P 500 ETF Trust (SPY) — Chart Source: TradingView

Using a far out-of-the-money bearish position, traders can add a little protection to their portfolios and set themselves up to profit if the market pulls back. SPY could retest support in the $331-$332 range, but if there is a more severe correction, it could fall back to old support in the $324-$325 range.

I’ve set the upper strike price for this ratio put debit spread at $325 because it is around an old support level, but it is far enough out of the money to let us enter the trade at a low price.

Using a spread order, buy to open 1 SPY March 9th $325 put and sell to open 2 SPY March 9th $315 puts for a net debit of about $0.05.

Note: Be sure you are opening the weekly SPY options that expire on Monday, March 9, 2020.

This is a high-risk trade, so take a small position.

About Ratio Put Debit Spreads

A ratio debit spread is simply 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 debit spread is a way to lower the cost of establishing a bearish put option trade. Many brokers will require the use of margin and/or a set amount of reserved capital to execute a ratio debit spread; contact your broker directly for specific requirements.

Because you are short a naked put in this ratio put debit spread, the risk is that you could be obligated to buy 100 shares of SPY at the $315 strike price for every 1 contract that you are short of the SPY March 9th $315 puts. So, this is inherently a higher risk play.

InvestorPlace advisor Ken Trester also brings you Power Options Weekly, which delivers 5 new options trades and his latest trading advice to you each Friday. 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.

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