Is the market correction finally here?

With weak economic data out of Europe and China, this month’s dismal jobs number and the selloff in commodities foreshadowing a slowdown in the global growth story, many traders believe the long awaited correction is finally upon us. E-mini S&P 500 futures traded at a high of 1593 last week and have backed off of that level by nearly 45 points. As we enter the heart of earnings season, results thus far have been mixed. It is clear now that the market is at a critical level. Either earnings will be strong enough to send us a leg higher, or growth concerns will send investors head for the exits.

So what can a trader do to protect themselves in a market this volatile? Unfortunately the violent moves over the past few days have brought about a spike in volatility. This means that short term downside protection is more expensive than it was when the market was at the height of the rally. That being said, many investors need this downside protection as concerns over the European debt crisis and growth in China are still very present.

So a trader still needs this protection, but wants to lower its cost in an inflated volatility environment.  The answer is the vertical put spread. The trader will buy an out of the money put while simultaneously selling a farther out of the money put. This caps the potential profit on the trade, but greatly reduces the trader’s initial premium outlay.

So what are the different instruments a trader can use?

  1. SPX options. These options track spot S&P 500 so they wouldn’t be the most effective hedge for a futures trader.
  2. The ETF. SPY tracks the index very well, but again this is not the most effective hedge on a futures position.
  3. E-mini S&P 500 Futures and Options. This gives a trader the best opportunity to set up a great risk versus reward trade while tracking the performance of the index very well. This is also one of the most liquid futures markets.

With ES futures trading around 1540 we can look at the May end of month (EOM) 1540 straddle to calculate a potential downside target. With the straddle trading around 62.50 we get a downside target of 1477.5. We can now use this target to set up a trade.

Trade:

Trade: Buying the May EOM ES 1500-1480 Put Spread for 4.25
Risk: $212.50
Reward: $787.5
Breakeven: 1495.75

This trade sets up a great risk vs. reward ratio that a trader can use as either a hedge or a speculation play if they believe the market will be heading lower.

 

About the Author
James Ramelli

James Ramelli is the Moderator of the Live Futures Options Trading Room at KeeneOnTheMarket.com where he actively trades futures and options on futures while educating members on strategies, setups and risk management. He has a degree in Finance with a focus in Derivatives Trading and Financial Engineering from The University of Illinois and has been trading for five years. James appears regularly on Bloomberg T.V. and BNN and writes a weekly column for Futures Magazine.

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