A Tale of Trading Chaos

Imagine a scenario where a Boeing jet experiences a catastrophic event mid-flight. In the midst of panic, one brave passenger takes advantage of the situation by logging into his brokerage account and purchasing Boeing put options. As news of the incident spreads and impacts Boeing stock, these put options skyrocket in value, potentially making the passenger a fortune.

However, before you get too carried away with this exciting tale, it's worth noting that this story is purely fictional. It serves as a meme created by traders who dreamt of what they would do in such a situation.

This fictional narrative sheds light on an interesting aspect of trading - the tendency to lose composure when chaos ensues. Investors often find themselves in a state of frenzy when unexpected events occur. They become consumed by worries and anxieties, overlooking the actual value of put options. In their desperation to protect themselves from a declining market, they are willing to pay exorbitant prices, unintentionally benefiting market makers who thrive on fear. (Puts are financial instruments that grant holders the right to sell an underlying asset at a predetermined price within a specific time frame.)

It's almost guaranteed that panic-driven puts are unlikely to yield profitable returns, just as surely as the stock market opens at 9:30 a.m. in New York. Yet, despite this knowledge, alarming market conditions push people to seek a false sense of financial security, even if their actions are economically irrational.

We previously highlighted the complacency of investors who fail to acknowledge the increasing risks present in our world today unless faced with something as significant as Boeing's recent mishap. If you agree with this viewpoint, then the challenge becomes finding a way to hedge against potential losses without falling prey to the market's tricks - particularly when your unrealized gains may be at an all-time high, considering the record-breaking levels of the market.

Our recommendation remains unchanged: the best strategy for mitigating risk is to sell puts on stocks that have proven successful when chaos strikes. By doing so, you position yourself as a dealer, taking advantage of overpriced puts eagerly sought by apprehensive investors.

In conclusion, while the story of the brave stock trader purchasing Boeing put options mid-flight may be nothing more than a fantasy, it serves as a reminder of the crucial role composure and rational decision-making play in the world of trading. Instead of succumbing to panic and fear, consider adopting a strategic approach that allows you to profit from others' anxieties while safeguarding your own gains.

Hedging Before Chaos Erupts

A more common approach, albeit trickier, is to hedge before chaos erupts. This strategy involves put spreads, which are attractive options for investors. Put spreads consist of buying one put and selling another with the same expiration but a lower strike price.

Choosing the Right Put Spread

Trading a put spread is not a one-size-fits-all approach, but starting with puts that expire in two months is a reasonable starting point. This expiration period allows enough time for potential events to unfold without incurring excessive costs for covering multiple outcomes.

Constructing the Hedge

To construct the hedge, it is recommended to choose a put that is approximately 10% below the current stock price. This percentage accounts for the initial decline before the hedge becomes active. Selling another put with an even lower strike price helps create a spread that could potentially yield a return of 100% or more.

An Example: Technology Select Sector SPDR ETF

Let's take a look at an example using the Technology Select Sector SPDR exchange-traded fund (ETF). With the ETF trading at $201.86, the March $180 put can be purchased for approximately 64 cents, while the March $170 put can be sold for around 40 cents. If, at expiration, the ETF is at $170, the hedge value would be $9.76 with an initial investment of 24 cents.

Risk and Adjustments

It's important to note that the hedge may fail if the ETF's price rises, resulting in the loss of most of the money invested. In such cases, the hedge can be reset at another two-month interval using updated strike prices to reflect market changes. However, resetting hedges can be costly if the market consistently drifts higher.

Taking Profits and Avoiding Greed

If the hedge proves to be profitable, it is advisable to take profits and avoid succumbing to greed. Many investors make the mistake of holding onto winning positions for too long, hoping to make even more money. However, it's crucial to remember that spread strategies have predetermined outcomes and to resist the lure of greed.

By employing hedging before chaos erupts and implementing put spreads, investors can potentially protect their investments while generating favorable returns.