Finding protection in choppy markets

January 30, 2014 05:06 AM

Yesterday saw broader markets sell off as the Fed elected to continue the taper of QE with another $10 billion reduction in its monthly bond buying program. Although this was a widely expected move, many traders believed that the Fed might choose to hold tapering amid the unrest in emerging markets. E-mini S&P futures (CME:ESH14) closed off the lows but firmly in negative territory. This morning saw the release of 4th quarter GDP and jobless claims. Markets are broadly up today as GDP numbers came in better than expected with the Commerce Department reported growth in the economy of 3.2%. Jobless claims, however, came in higher than expected showing shakiness in the labor market. Markets are also lifted by a slew of better than expected quarterly earnings released today. With turmoil in emerging markets continuing and mixed data coming out of the U.S., it is clear that traders are facing a lot of uncertainty right now. With such an increase in volatility, many traders are looking for protection against their long positions. For traders looking to hedge, there are several different products they can use.

  1. SPDR S&P 500 ETF Trust (SPY). This ETF tracks the performance of the S&P 500 very well. Traders who are looking for a hedge against their long book can consider shorting the SPY outright or using SPY options. These options are very liquid and trade like standard equity options.
  2. Shorting Individual Stocks. A trader can look for short positions in individual equities to balance out their book. This method also allows for a trader to pick and choose which positions they want to be long or short. This is a rather capital intensive way to hedge, however.
  3. E-Mini S&P 500 futures and options. This is the cleanest way to get exposure to the index. Futures and options on futures also provide inherent leverage that allows for a much more efficient hedge.

We can see that using futures and options as a hedge is the most efficient way to trim long exposure. Let’s look at some different strategies a trader can use to hedge themselves. With ES futures at 1,780 and March options implying a move higher or lower of 75 points, we can look to set up a hedge with a downside target around 1,705.

Hedge #1: Buying the ES Mar 1775 Puts for 35.00 Risk: $1,750 per 1 lot Breakeven: 1,740

This is a rather expensive hedge but will protect a trader against losses anywhere below 1,740. This lines up near key support levels and would shield a trader from a break of that level.

Hedge #2 Buying the ES Mar 1775-1720 Put Spread for 16.00 Risk: $800 per 1 lot Reward: $1,700 per 1 lot Breakeven: 1,759

This trade requires a much smaller amount of initial capital, but does not offer a trader protection against losses below 1,720. This hedge is more conservative but would still provide protection against a move lower in the market.

With so much uncertainty in world markets, many traders are looking for protection. It is important to consider the more efficient way to buy this protection, and using options allows for this efficiency.

About the Author

James Ramelli is the Moderator of the Live Futures Options Trading Room at 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.