The Big Put To Maximize Potential Gain But Limit Risk

The S&P500 is in a very precarious position and looks set to drop over the coming months. After the Brexit risk rally, where it appeared that central banks would once again step in with yet more stimulus and QE, the S&P500 broke out to new highs, but since then it has dropped back to the top of its year long range and is acting in a manner that would suggest it is going to fall back through this support.

Technically if we break below 2100 on the SPX, we should at least test 2000, and more than likely the bottom of this large range at 1800 over the following months. The recent price action is that of a tired market, a market with no impetus to rise and in addition, sentiment isn’t bearish at these levels for a change, hedge funds in particular are Net Long…and everyone is expecting the same yearly cycle of a year-end rally after the election.

Trump Card

Fundamentally and politically there are also quite a few factors which could cause a risk off period in the markets. We are coming up to an election where the two candidates are possibly the most disliked potential presidents in American History. It looks very likely that Hillary is going to win, however as we have seen with Brexit anything can happen. There are a lot of voters out there who are not comfortable revealing that they would vote for Donald Trump, but in the privacy of a Polling booth it’s a different story. A Donald Trump win would be a shock and quite a large risk event in the markets. The initial uncertainty combined with his hostility towards the Federal Reserve would cause a sell off, as this market rally has been on the back of low rates and QE from the Fed. I personally don’t think that a Donald Trump presidency would be bad economically for the US, the stage has been set for that already by years of borrowing for consumption and the misallocation of capital and resources. However the market could tend to over react initially, similar to Brexit.

Expect the media to cover this in their usual way, headlines will be “Flash Crash 2.0”, or “The Trump Crash” etc. If Clinton wins the market may hold up a little longer before selling off, this Sell off will probably be blamed on nervousness around the Fed raising rates, headlines such as, “Fed Fears” or “The Equity Tantrum” will abound.

Hawkish Central Banks and European Divergence

As well as the election, we have in addition, a much more hawkish tone coming from central banks globally, it would appear that they are starting to realise that QE doesn’t actually provide economic growth or stimulus to the real economy. The Fed is set to raise rates in December, the ECB is slightly more hawkish in tone than normal and are unlikely to increase QE to the extent to which the market had initially expected, although it appears they will continue their bond buying programme past March.

Already we are starting to see the rotation and shift between European and US Equity markets for the first time in seven years. Over the past month the EuroStoxx and DAX have rallied, while the SPX has gone sideways. We have not seen European outperformance for a long time. This is due in part to the change in Central Bank policy in the two regions. However, this rotation can also be indicative of a top in US markets, and hence equities globally.

Expect Europe to catch up fast on the downside and overtake the US markets should this S&P500 rollover

Strong Dollar

We also see the US Dollar starting to strengthen considerably over the past month. Moreover, it looks like it is on its way to making new highs this year. This could potentially signal the beginnings of a flight to safety and of stresses in the financial markets globally.

The Real World

The average person is not better off since the crisis of 2008…nothing has changed. All that happen was interest rates were dropped to zero, banks where bailed out, and QE was initiated. All of this was enough to stop the system coming to a halt. It papered over the cracks, allowed governments and businesses to get into even more debt, meaning that when the next down turn comes it will be larger in dire magnitude than in 2008. This will create lots more opportunities for the prepared investor. It’s FAR from ideal that our economies are run this way, but we know they are. Therefore what’s in our control is to adapt and be positive in looking for the opportunities as they appear.

The Big Put

My preferred method of capitalising on this potential equity sell-off would be an options play, buying March 1800 S&P Puts. I think that this market will start to come off gradually…and then there will be a large volatile drop, similar to what we saw in August 2015. However, this time there would be the added selling of those who bought the new highs, now trying to liquidate as the market drops back to the bottom of the range it had just broken out of. This final sharp drop could be 5% Plus - and this is where holding the options pays off as this sharp drop will increase the value of the options exponentially…providing you are quick enough to cover once this drop comes. Buying a Put also has limited downside, which means you can only lose the amount which you purchased.  Prudence demands I would only ever make a trade where I already know my maximum downside risk.

Gold

Now is a good time to lighten up on equities in order to rotate into precious metals and precious metals miners. Don’t expect the miners to get dragged down with the overall market this time like they did in 2008, I hear this line regurgitated all the time as if history exactly repeats. It doesn’t. Although it does occasionally rhyme (I’m aware of the Ironic Regurgitation).

Peter Hegarty

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Disclaimer: This is not financial advice or a recommendation to Buy or Sell. This is my own personal opinion based on my analysis of the markets over the last 15 years.

Always consult your financial adviser before changing or making any financial investments.