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Hedging Friday’s Jobs Report

Investors and traders rejoiced yesterday morning as reports from ADP showed that private payroll numbers grew 110,000 in October, nearly 10% above the consensus estimates of economists. There was additional positive news, showing that September numbers were revised to show a gain of 116,000 jobs, up from the previous reading of 91,000. Benchmarks were positive throughout the mid-week session, despite tons of news, including a Fed meeting and subsequent news conference from Fed Chair Bernanke, the S&P 500 Index (SPX) was in positive territory for the entire session.

However, let’s not celebrate just yet. The monthly Employment Situation Report is very tricky and volatile. Comprised of two separate surveys, the jobs picture has seen revisions that are larger than the original reported number. Friday’s government report may extinguish the hope and euphoria created by the ADP numbers. Therefore investors should be prepared in case the Bureau of Labor Statistics report disappoints, with non-farm payrolls coming in below estimates. Even if the report comes in on the money, many may be disappointed since the ADP report was stronger-than-expected.

Currently, short-term options on the SPDR S&P 500 ETF (SPY – $123.83) are showing a 0.7% implied move as of Wednesday night’s close. That means that SPY has the potential to move 0.87 points for the remainder of the week. If traders are disappointed, selling pressure could result in a move greater than that.

WHAT DO YOU DO ABOUT THE RISKS?

Let’s look at a hedge idea for a portfolio with a high correlation to the S&P 500 Index (SPX ). Take the value of that portfolio and divide it by 12,400. That is the number of contracts that you will want to buy to hedge your portfolio. Given that implied volatility is higher, off of the recent lows set late last week, we suggest buying the following the 1-by-2 put ratio spread, with expiration for this Friday!. Buy SPY Nov 4 – 124 Puts at $1.23 and sell twice as many of the Nov 4 – 120 Puts at $0.21, for a $0.81 net debit (prices are based on Wednesday’s closing quotes).

If the market drops, and SPY ends at the $120 strike price (down 3% from current levels) on Friday evening, the maximum profit will be realized, measured to be $3.19/per share. If the shares are above the $124 strike, a maximum upside loss of $0.81 per share will be realized. There are two break-even points for this strategy: 1. SPY at $123.19 and 2. SPY at $116.81. If the shares move below the $116.81 level, you will lose $1 for each point below that level.

This is not a strategy for those that don’t know and understand options. The strategy is meant to hedge a portfolio and not for profiting. There is some extra risk due to the extra naked put, which will require a higher margin requirement (check with your broker).

For more information, email me at sfullman@increasingalpha.com and I will attempt to respond to all queries.

 

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