[Options] A Hedge Against Long Exposure

Sean McLaughlin
June 30, 2021

Whether you know it or not, we're all exposed to risk from the financials sector (think big banks, GE, etc).

And when I look across the positions in my portfolio, I have significant open exposure on the long side of the market.

This is top of mind for me right now, coming out of our weekly team call. The recent sloppy market action, with no real expansion of new highs, is opening the door -- if ever so slightly -- for the bull market doubts to creep in. We are certainly not making a "Top" call here by any means, but we are observing that the risks of a potential correction appear to be increasing.

So, while we don't need to get aggressive with short bets here, it might be prudent to start exploring some bearish setups and keep our eyes and minds open for opportunities to get tactically short in names and sectors that would likely lead on the downside if the broader markets were to stumble here. And we can do this without exposing our portfolio to too much risk, thanks to the existence of long exposure already on the books.

The first idea I have for dipping our toes in the water is centered on the financials. We've seen some great runs in individual names here, but a quick look at the sector ETF $XLF shows that we might have run out of steam:

Couple this with some pretty cheap options premium as inferred by this chart of implied volatility over the past year in $XLF:...and this sets up a great opportunity to participate on any downward momentum pretty easily.

Here's the Play:

I'm buying $XLF November 34 Puts for approximately 87-90 cents per contract. This debit is the most I can lose if XLF does not follow through with any further downside action. Since it's possible I can lose 100% of the premium in this trade, I'll size my position accordingly.

If $XLF flies in our face and breaks back above early June highs, then I'll look to close the puts and salvage whatever I can. That would be a screaming signal to me that we're either early or just flat out wrong. Either way, I'm out.

But if the market does begin to crack and it's lead by the financials (as we think it would be), then I'll look to sell half of my puts when I can do so at a double of what I paid (so around $1.80 credit). This will remove all of my original risk capital from the trade and allow me to hold on for potentially larger gains.

Because bear market bounces tend to be vicious, I'll look to be opportunistic in taking additional profits. Steve Strazza said: "there's a lot of dead bodies at 31-ish and the primary trend is still up." And he's probably right. But if $XLF sees $27 (an optimistic, but not unrealistic level based off November's gap), then I'll look to take the rest of the position off there for a significant gain.

If we see neither 27 nor new highs above $38.60 and I'm still holding a full or partial position on November 1 (expiration month), then I'll aggressively trail a stop at a 3-5 day high as long as the puts are in-the-money (XLF is trading below our $34 strike price) as long as I can towards expiration. If XLF is above 34 on November 1, then I'll just close the position down for whatever I can get for it (if anything).

ASO subscribers can send any questions on this trade here.

~ @chicagosean

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