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- The stock market may seem calm right now as it chugs towards a new record, but that’s exactly the time traders should be seeking hedges at discount prices.
- The derivatives strategy team at Goldman Sachs has identified an attractive long-term hedge that’s the cheapest it’s been since before the financial crisis.
If you follow the stock market in any capacity, you’ve probably sensed a bit of malaise in recent weeks.
Yes, equities rebounded sharply in the immediate wake of December’s near-bear market. But it’s been a snooze since then, with price swings dropping back down near historical lows.
Goldman Sachs attributes this to a few things: improving economic data, a Federal Reserve that’s signaled it won’t tighten monetary conditions in the foreseeable future, and low volatility in other asset classes (most notably rates and currencies).
Those elements have combined to create a sense of complacency among investors — one enabled by the S&P 500‘s torrid rally back near all-time highs. Amid this perfect storm of bullish conditions, they seem content to kick their feet up and let the slow churn higher progress.
But while conditions may seem thoroughly positive on the surface, that lack of urgency can leave traders ill-prepared for future bouts of turbulence. That’s especially true amid low market-wide liquidity — something that’s been frequently cited as a ticking time bomb by Wall Street experts.
"Equity markets remain vulnerable to sudden shifts in volatility," Rocky Fishman, a derivatives strategist at Goldman, wrote in a recent client note. "Conditions can change quickly, especially with diminished liquidity."
In Fishman’s mind, the best possible thing an equity trader can do at this point is load up on downside protection — just in case. And wouldn’t you know it, he finds that one specific type of hedge is the cheapest it’s been since before the financial crisis.
He’s referring to the following strategy: Buying S&P 500 put contracts costing $85.20 and expiring in January 2020 — at a strike price of 2,750 — versus a June future reference price of 2,910.
"The 0.8% of spot price difference between a 9-month 95% SPX put and a 6-month 95% put can be thought of as a rough three-month carry cost of an SPX longer-term hedge," Fishman said. "That cost is now the lowest it has been since 2007."
Ultimately, this approach is designed to simultaneously acknowledge that the currently placid environment could persist for a bit longer, while also taking advantage of inexpensive hedges for the long term.
"While we see no key imminent catalysts, low-vol periods are a good time to accumulate mildly-carrying, longer-dated protection," he said.
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