In this post, we offer an iShares Russell 2000 Index (IWM) conditional hedge idea for the occasion.
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Strategy
Two weeks ago we wrote, “Although the market appears extended until an unbalancing force triggers a correction it should keep trending higher.” Now with the chatter beginning about the US Government spending sequester, due on March 1 we think the balance is tipping in favor of a more cautious stance since the unbalancing force could be set in motion with the sequester that some political pundits think is now very likely.
As for volatility, both implied volatility and historical, we know from experience they revert to their means and both are now well below their mean values. Therefore, when the correction gets underway volatility will increase so think in terms of option strategies that benefit from increasing volatility such as put ratio backspreads with more long options than short or long straddles and strangles. Since the VIX implied and historical volatilities are also quite low, a long VIX call is another alternative. However, keep in mind, counter-trend trades need close attention since the corrections are usually brief.
IVOLopps? – Correction Hedge
With the preface that previous counter-trend hedge trades suggested since November have not been necessary and reduced portfolio returns, here is a contingent April put spread to consider in the event the correction is about to begin.
iShares Russell 2000 Index (IWM)
We begin with the option data.
The current Historical Volatility is 8.60 and 7.99 using the Parkinson’s range method, with an Implied Volatility Index Mean of 13.63, down from 14.40 last week. The IV/HV ratio is 1.59 and 1.71 using the range method to calculate the HV. The put-call ratio is bearish at 2.0, but it is a hedging favorite so high ratios are normal, in fact, 2.0 is in the lower part of the range. Friday’s volume was 812,233 contracts traded compared to the 5-day average volume of 596,730.
On the correction, as volatility increases, we estimate the implied volatility could return the 20 area.
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With decent volatility edge and enough time to expiration, the cost is 25% of the distance between the strike prices giving a risk to reward ratio of almost 3 to 1. However, this is a contingent suggestion deferred until IWM closes with a lower high and lower low, which it has not done since February 4.
The suggestion above uses the closing middle price between the Friday bid and ask. Tuesday the option prices will be somewhat different due to the time decay over the weekend and any price change.
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Summary
Increasing talk about a US Government spending sequester along with declining momentum suggests a correction from the breakout above 1460 on the S&P 500 Index that according to some market commentary is long overdue, could be triggered by extensive media coverage of the sequester.