Market Hedge: If the S&P 500 Tests the Bulls Will

The commencement of the second quarter for U.S. equities has been characterized by turbulence. The question arises: is this the onset of a pullback or merely a transient hurdle in this nascent bull market?

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Over the past five months, the S&P 500 has surged by more than 21%, exhibiting a sharp upward trajectory that prompts me to consider establishing a hedge. My objective is twofold: safeguarding profits and leveraging potential opportunities should the S&P 500 pivot and challenge the prevailing bullish sentiment in the short term.

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The first quarter witnessed the S&P 500 clinching a remarkable 10% gain, marking its most robust performance at the year's outset since 2019. This commendable showing in Q1 adds to the momentum generated by the 12.5% surge observed when market participants re-entered the fray in November and December.

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However, Thursday witnessed a resurgence of volatility as equities faltered, culminating in an uncommon trading session marked by an almost 2% intraday bearish reversal in the SPDR S&P 500 ETF (SPY). The CBOE Volatility Index, known as the 'VIX' or the fear gauge, surged to its highest level of 2024, albeit still residing at historically subdued levels, closing at just 16.

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Amidst this backdrop, markets grapple with uncertainties surrounding inflationary pressures and mounting skepticism regarding the Federal Reserve's steadfast commitment to its interest rate trajectory. A recent uptick in oil prices, a harbinger of inflationary concerns, might dissuade the Fed from embarking on its anticipated interest rate-cutting campaign in 2024. Nonetheless, the Fed may find solace in a jobs report that exceeded expectations.

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Further reinforcing my short-term bearish stance is the recent uptick in U.S. Treasury yields, reflecting market skepticism regarding the Fed's pledge to implement "three cuts" in 2024. Following the release of nonfarm payrolls data, the 10-year yield surged to 4.40%, marking an increase of more than 50 basis points since the beginning of 2024. This deviation of equities from their traditional correlation and sensitivity to interest rates raises concerns for me.

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In light of these considerations, I am inclined to execute a hedge trade focused on the SPY:

• Purchasing a SPY Put Spread with a regular May expiration:
  • Bought the regular expiration $500 SPY put expiring on May 17, 2024, for $4.25
  • Sold the regular expiration $480 SPY put expiring on May 17, 2024, for $1.80
  • The net debit for establishing this put spread amounts to $2.45, equivalent to $245 per spread.

In the event of a retracement of the S&P 500 to January levels around 4,950, the put spread would come into play, yielding a profit of $1,755 ($20 difference between the $500 and $480 strike prices minus the initial $2.45 premium). Conversely, should the market rally, the defined risk inherent in this spread would mitigate any potential losses incurred from long equity exposure to the S&P 500.

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Flexibility remains paramount in navigating these volatile market conditions.

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