After a rocky start, the S&P 500 has delivered an impressive year. From its April lows, the index has surged as much as 43% and consistently held above its 50-day moving average.
However, cracks are beginning to appear. Many analysts have raised concerns about stretched valuations — particularly among the highflying Magnificent Seven. That group now accounts for an increasingly large share of the index.
With the S&P 500 once again testing its 50-day line, investors should be cautious if it closes below that level. That hasn’t happened in the past six months.
If that breakdown occurs, investors can position for further weakness by trading a bear put spread on the SPDR S&P 500 (SPY) exchange traded fund. The ETF is often known by its ticker — SPY.
Constructing A Bear Put Spread
In constructing a bear put spread, an investor buys a put option while also selling a lower strike put option. In the case of SPY, investors can consider a bear put spread by buying a 650 put while selling a 630 put on a Dec. 19 expiration.
This trade recently cost a debit of around $3 a share, or $300 per set of put contracts. This also coincides with the maximum loss of $300 an investor will experience on a 100-share contract if shares of SPY are above 650 on expiration.
The maximum profit amounts to the width of the strikes minus the debit paid. In this case it’s $20 minus $3 times 100, or $1,700. Investors will realize this maximum profit if shares of SPY trade below 630 on expiration.
This spread is particularly useful as a hedge against other positions in a portfolio. Because the risk is limited, traders can comfortably hold the position through expiration.
SPY ETF: Taking Profits Early
However, thanks to SPY’s deep liquidity, investors can also easily take profits early by closing out the spread if a market drop looks overdone.
While this spread offers an attractive risk profile, it will quickly lose value. It also will likely expire worthless if the indexes continue to grind higher or move sideways. However, if markets decline meaningfully, investors are well-positioned to earn several multiples of the original debit paid.
Investors who believe richly valued tech stocks will lead any decline can take a similar approach by betting against the Nasdaq 100.
In that case, you can buy the 580/560 bear put spread on the Invesco QQQ Trust ETF (QQQ) for the same Dec. 19 expiration, which currently offers a comparable payoff structure.
Steven Bell is a writer and trader based out of Vancouver, British Columbia. He is the author of IBD’s Income Investor column, focused on shedding insight on low-risk, underfollowed stocks.
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