Last week brought more volatility and weakness to all the major averages. Technology (QQQ) shares led the decline, with that index hitting two-month lows. Last week I suggested owning August VIX calls or call spreads (here), and the VIX index jumped ~ 25% to end the week on the highs (VIX August futures rose ~ 5.5%). While I suggested owning VIX structures as more of a tail hedge for the market, I now believe investors need to be more aggressive with their index hedges given the action I am seeing.
QQQ with a break below recent support after failing to make a new high on the June market rebound
VIX index broke above the March downtrend after holding support once again at the 15 level
With tech leading the selloff, it makes perfect sense to consider owning QQQ hedges, especially as we are about to start earnings season for most of the largest names. With that being said, I actually believe that SPY hedges offer a better risk/reward profile at this time. There are a few reasons why I prefer SPY hedges now. First, SPY puts are CHEAP to QQQ puts on a historical basis. The 1-month (Aug) SPY 40-delta puts currently trade at a 16.25 implied vol, while the same duration/delta QQQ puts trade at a 27.50 IV. This put skew means that SPY puts only cost less than two-thirds of what QQQ puts cost (the actual number is .59), which means they are trading just above the cheapest skew in the past 5 years. Put another way, QQQ would have to underperform SPY to more than a 1.6x beta to make owning those puts a better option than SPY puts (QQQ beta to SPY YTD has been closer to 1.4x)
SPY 1-month (Aug) 40-delta puts are trading near their cheapest levels to QQQ puts in over five years (bottom chart)
Second, the Mag7 (MAGS) were a big reason why both QQQ and SPY were unable to make new highs in June, even though the memory/AI trade was working extremely well. With the sharp correction we just saw in that AI momentum trade, clearly a lot of that money flowed back into the Mag7/hyperscalers. That dynamic helped close the very wide gap between where SPY and MAGS had been trading. Now that they have “caught-up”, any weakness by those heavily-weighted names from here is likely to put downside pressure on the S&P. The Goldman Sachs High Beta Momentum index also pulled back to the recent support, which could be signaling a rotation back into the momentum trade (at the expense of the Mag7 once again)
We saw the Mag7 (MAGS) close the gap to SPY as money came out of the AI momentum names the past few weeks
The Goldman Sachs high beta momentum index with a pullback to the recent lows (could be signaling another potential rotation)
Against this backdrop, SPY is only down ~ 2% from the all-time highs that were established in early June. This is with oil starting to move back higher as geopolitical concerns are ignited once again, and with yields unable to move down meaningfully (even on somewhat benign inflation reports). The sharp rotation back into the Mag7, as well as financials, helped mask a lot of the weakness under the hood (specifically in the AI momentum trade), but as we head into earnings for the group, I’m just not sure how much further heavy lifting they can do? As it is, Apple (AAPL) has risen by 22% since the momentum basket peaked on 6/25, and it now trades at nearly 40x.
Oil has risen by ~ 23% off the recent lows as tension in the Middle East are back on the rise
10-year yields remain just below their May highs, even as the recent inflation data came in on the dovish side
Looking at the SPY chart, it was also unable to eclipse the early June highs, even as the heavily-weighted Mag7 and financials were attracting flows as the AI momentum trade was being unwound. SPY closed below the 50-day on Friday, and appears to be in danger of further declines, especially if we see money leave the groups that did most of the work on the latest move higher off the late June lows. On a tactical basis, I would be targeting a pullback to the 695-700 area as it appears that should be the next major support level. Not only is the rising 200-day moving average support at that level, but that was also the former highs from Jan/Feb and is also represents a 50% retracement of the move off the March lows to the June highs.
All roads lead to 695-700 for SPY should we see a more meaningful decline
Even though SPY puts trade cheap to QQQ, and implied vol is still closer to the 6-month lows, I still prefer to own August put spreads over outright puts that target a potential decline to that 695-700 level I mentioned above. Owning a put spread will reduce the cost of the hedge, while also capturing ~ 6 points of vol skew.
Trade:
Buy SPY August 21st 730 puts
Sell SPY August 21st 690 puts
Costs ~ $5.80 (SPY 743.29 Fri close ref)
Trade Details:
- Buying the SPY August put spread for an index-level hedge as we head into earnings season for the Mag7
- Hedge starts ~ 2% lower and offers a nearly 6x to 1 max payout on expiration
- Selling the 590 put covers 35% of the cost of owning the much closer to the money protective put
- SPY vol trading near cheapest skew to QQQ vol in the last 5 years
- Could start to see another rotation out of the Mag7/hyperscalers and back into the AI momentum names (much like we saw thru most of May and June)
- Higher oil prices and yields could start to weigh on stocks again
- Put spread is capped to the downside at 690. This is not only more than 7% lower, but is also just below what I expect to be strong support (200-day, former highs and 50% retracement)
- Please reach out to me or the 22V sales team for updated pricing and execution capabilities
