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When to look for protection
Clint Cowles, 08/08/2019
Senior Strategist, Institutional Trading Education, TD Ameritrade Institutional
It might sound overly simplistic, but staying invested in the market hinges on whether or not the market is still in an uptrend.
The tricky part about that is nobody knows exactly when it will end or what it will look like when it does. So what is an investor to do? Randomly pick a time and start selling as price is still rising? Oftentimes this has them out of the market way too early, missing out on potentially significant gains. Wait until the market is in “bear market territory" after a 20% fall? That's certainly an option, but the market is already down 20% and, if history repeats itself, likely nearing a bottom. A third option would be to employ a combination of technical analysis and option protection strategies that will allow you to stay invested yet limit your downside if things start to get ugly. Most portfolios tend to have a fairly positive correlation to the S&P 500 (SPX), so let's use that as an example for this exercise.
Source: thinkpipesÆ. For illustrative purposes only
This is a weekly chart of SPX from the beginning of 2017 through today with two linear regression studies placed over the prices. These studies create a least squares calculation to draw a straight line through the center of the closing prices over the last ten years. That sounds complicated, right? Simply put, linear regression analysis helps forecast trends by looking at price history over a certain timeframe. In this case, I used ten years because our bull market is ten years old. Once the center line is calculated it will find the single closing price furthest away from that line and plot another line parallel to the first. Lastly, it will plot a third line equidistant from the center line on the other side. (LinReg100) The second study (LinReg50) simply plots two more lines halfway between the center and outside channel. These channel lines often act as support or resistance, and in this case SPX has bounced off of them multiple times over the past few years. SPX came very close to the 50% resistance level (orange oval) back in April before selling off. We are now right back at that same line and so far appear to be selling off from that resistance point
Another common way to draw resistance lines is simply to connect two previous peaks with a trendline and extend that trendline forward in time. This is represented by the red line from the January top to the September top and extending forward. This just so happens to correspond with the linear regression line resistance that SPX just hit. So from a technical perspective it looks like there is a greater potential for a pullback in price from this level. However, this does not mean our bull market is over, and just selling out of a portfolio brings us back to our first question. Another possibility would be to construct a protective strategy to limit losses while waiting for the price of SPX to find more stability.
One example of such a strategy would be buying a put spread using SPX options. There are many variations of this that could accomplish similar goals—and to help identify some of the best possible choices for your situation give the TD Ameritrade Institutional Strategy Desk a call—but here is one example that could accomplish this goal. Here, we'll purchase a 10% wide put spread with a six month expiration, with protection starting only 5% below the current market at $2,800. Just purchasing put options there alone can end up being a bit expensive, so in order to reduce the cost we'll move 10% down the option chain and sell another put at $2,500. As of this writing, this can be done for right around 1.5% of the portfolio or about 3% annualized. The risk profile graph below outlines how this portfolio will react if the SPX does indeed follow through with further declines.
Source: thinkpipesÆ. For illustrative purposes only
Since the protection doesn't kick in until $2,800 a drop down to that level is the same as without protection, however once it moves past $2,800 this spread gets to work. You can see that the Profit/Loss graph completely flattens out in between $2,800 and $2,500, meaning that if the SPX were to continue dropping, this portfolio just wouldn't participate for the next 10%. If it were to continue past that then this portfolio would again begin to experience losses. This can be an attractive alternative to either selling out too early, or waiting for a large correction to sell into. Although it does come with a cost, it allows for continued exposure to the market in case it continues to rise. Yet it is designed to limit the downside loss in case of a decline from resistance.
Commentary provided for educational purposes only. Past performance of a security, strategy, or index is no guarantee of future results or investment success.
While these principles are the foundation of technical analysis, other approaches, including fundamental analysis, may assert very different views.
Content provided is for educational purposes only and is not intended to be advice for any firm.
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