The only certainty when it comes to trading the financial markets is that there will always be periods of uncertainty. There are times when it seems like stocks will only go up. During those periods, it becomes increasingly difficult even to spot a potential catalyst for a sell-off… enthusiasm abounds.
However, we know that the good times won’t last forever. Sometimes the reason for a market pullback may be very temporary in nature. Other times, something like a major shift in economic data portends a longer period of pressure on stock prices.
It’s the temporary catalysts that are typically the hardest to spot and tend to catch traders and investors off guard. For instance, the spread of the coronavirus in (and out of) China is the most recent event to cause a sharp drop in stock prices.
The highly contagious virus seemingly began to spread in Wuhan, China, a city of 11 million. It has since spread to other cities in China and several countries around the globe, including multiple cases in the US. Because the virus can have a long incubation period and appears to be highly contagious, there is concern that the coronavirus may lead to a pandemic.
While the virus may not be as deadly as previous pandemic scares (thankfully), it also has the potential to spread faster and may be harder to detect. Furthermore, in order to contain the virus, China has essentially locked down parts of the country. Economic activity in some areas has essentially come to a screeching halt.
Given how many goods and resources come from China (and are shipped there as well), the coronavirus is already having a major impact on the global economy. That’s why we saw global stock indices sell-off sharply at the start of the week. And, until the virus is contained, there may continue to be bouts of high volatility in the financial markets.
So what can you do to protect your portfolio in this situation?
An interesting defensive choice in this situation is utility stocks. What’s interesting about it is that utilities are generally considered defensive stocks that go up or hold steady when investors are taking fewer risks. However, in a major sell-off, even utilities may go down with the broad market.
That’s what makes this put trade in SPDR Select Sector Utilities ETF (XLU), a thought-provoking case study. XLU is a popular way for investors to gain exposure to utilities. The ETF is up about 28% over the last year, which is a lot for a defensive sector.
A large trader opened a very large put position in XLU expiring in February. With XLU at $68.50, the trader bought 10,000 of the February 21st 67 puts for $0.30. That amounts to $300,000 in premium and is the max loss on the trade. The breakeven point is $66.70, and any point below that is profitable by February expiration.
So the question is, is this a hedge against a long stock position in XLU, or is it a bet that XLU is going to drop after its recent sharp move higher?
You can see from the chart that XLU has definitely gone parabolic in recent weeks. The put trade could be a straight-up bet that the ETF is going to mean revert if the market continues to experience high volatility.
On the other hand, XLU will probably outperform other sectors if the stock market turns more bearish moving forward. In that case, a 30 cent option could be a cheap hedge against a very large stock position in utility stocks.
Either way, this trade is certainly on the defensive side. That is, either someone expects a big drop in the broad market, or they are protecting an already defensive position (long utilities) with puts.
This chart could make today the easiest time in history to retire and feel rich while doing it.