Traders anticipating a potential stock market crash in the coming year are presented with a rare opportunity. According to analysts from BofA Global Research, the cost of protecting against a market downturn has reached its lowest point since 2008.
In a recent report, Benjamin Bowler, BofA’s renowned global equity-derivatives strategist, revealed that “since our data began in 2008, it has never cost less to protect against an S&P drawdown in the next 12 months.” This signifies an exceptional chance for traders seeking to hedge their investments.
Several factors contribute to this favorable scenario. The combination of relatively low equity volatility, anticipated interest rate hikes by the Federal Reserve (with an expected 25 basis-point increase on Wednesday), and low correlation among various sectors of the stock market has created a truly historic entry point for implementing hedges, as outlined by the research team.
The team further mentions that the cost of purchasing S&P 500 puts and put spreads with a 12-month expiration is currently even lower than it was in 2017. It is worth noting that in 2017, the Cboe Volatility Index (VIX) – often referred to as the “Vix” or Wall Street’s “fear gauge” – reached its all-time low below 9. Despite trading higher at 13.86 on Tuesday, the current VIX level still presents an enticing opportunity.
To clarify, a put is an option contract that offers potential gains if the underlying stock or index experiences a significant decline within a specified timeframe. The strike price represents the threshold at which the option becomes profitable. Traders often exercise or sell “in the money” options for a profit, provided that the cost of purchasing the option has been offset. Equity options grant traders the right to buy or sell, without any obligation to do so.
This unparalleled window of opportunity in the market allows traders to seize an advantageous position by using hedges to protect against potential downturns. With the cost of protection lower than ever, traders can tactfully navigate these uncertain times and safeguard their investments.
In the world of options trading, there is a particular strategy known as a “spread.” This strategy involves selling one option contract to help cover the cost of buying another.
Our team highly recommends buying put options that would yield a payoff if the S&P 500 were to decrease by 5% over the course of the next year. However, for those investors looking to make a greater impact, we also suggest a put spread tactic. This entails selling a put option for the S&P 500 that is even more out-of-the-money to offset the expense of purchasing the aforementioned 5% out-of-the-money put option.
What makes this strategy particularly attractive is that the upfront premiums paid for such trades are in the low single-digits. This means that the cost of protection is quite minimal, merely a few cents on the dollar.
If the S&P 500 experiences a decline, the put spread recommended by our team has the potential to offer a maximum payout of over 8-to-1.
Increasing Stock-Market Risks
Interestingly, the cost of bearish options on the S&P 500 has become remarkably low to the point where it seems almost illogical. With the current market conditions, there appear to be far more potential hazards within the stock market than there were in 2017.
On Tuesday, U.S. stocks displayed positive performance. The S&P 500 rose by 0.3% to reach 4,567.46. Simultaneously, the Nasdaq Composite increased by 0.6% to reach 14,114.56, while the Dow Jones Industrial Average rose by 26.83 points or 0.1% to reach 35,438.07. Additionally, this marks the longest winning streak for the Dow Jones Industrial Average in over six years.