For the past two weeks, I’ve been relaying the market warning signs that I’ve seen to my Cabot Options Trader and Cabot Options Trader Pro subscribers. Many of the signs have come from the stocks and sectors that make up the “Trump Trade,” which has led the market higher since the U.S. election.
Here are some of the yellow flags I’ve recently noted and highlighted to my subscribers:
- Leading financial stocks such as Goldman Sachs (GS) and Bank of America (BAC) are both down more than 7% over the last month.
- The Transports have also sold off, with stocks such as Delta Airlines (DAL) and XPO Logistics (XPO) down over 8% during the last month.
- Oil is down nearly 12% the last two weeks.
- Materials stocks such as United States Steel (X) and Cliffs Natural Resources (CLF) are down 11% and 25%, respectively, over the last month.
- While the S&P 500 advanced early in the year, the Russell 2000 is making new 2017 lows.
- The Dow recently fell for eight straight days, its longest streak since 2011.
That said, I see plenty of positive signs in the market as well. Here are those bullish signals:
- Leading growth stocks such as Facebook (FB), Netflix (NFLX) and many others are within a couple percent of all-time highs, and barely flinched as the market recently pulled back.
- The Chicago Board of Options Exchange Volatility Index (VIX), which is often referred to as the “fear index,” is still trading below 15, which is the level at which I start to get a bit concerned.
- My Options Activity Scanner has yet to pick up on big put buying in leading stocks or the major indexes.
All in all, I remain bullish because this feels like an ordinary minor pullback. However, I do have an eye on the warning signs I noted above.
How to Hedge Your Portfolio with Options
So how am I managing our options portfolio if I’m bullish, but concerned? Let’s take a look at how I’ve managed the Cabot Options Trader portfolio as I became concerned with the market.
Here’s what the portfolio looked like heading into last week:
- Long Oracle (ORCL) June 44 Calls (had sold half for a profit of 170% the prior week)
- Long Symantec (SYMC) April 24 Calls (calls were at a profit of over 200%)
- Long Microsoft (MSFT) April 52.5 Calls (holding half a position, after selling the first half for a profit)
- Long Coca-Cola (KO) May 42 Calls (the position was at breakeven at this point)
- Long Astra Zeneca (AZN) July 30 Calls (position at a profit of 100%)
- Long United States Oil ETF (USO) via a Buy-Write (position at a loss, but had been selling calls to lower our breakeven for months)
- Long Builders Firstsource (BLDR) via a Buy-Write (position at a breakeven)
Evaluating the portfolio, it was clear to me that I was overweight Nasdaq stocks (ORCL, SYMC and MSFT), while the rest of the portfolio was fairly diverse, with a consumer staple (KO), pharmaceutical (AZN), commodity (USO) and infrastructure stock (BLDR).
Because I was overweight Nasdaq stocks, with the Nasdaq ETF (QQQ) trading at 130.50, I recommended the purchase of a Nasdaq (QQQ) put. Here was that trade:
- Buy to Open the QQQ September 129 Put (expiring 9/15/2017) for $5.21.
This put, which was trading approximately 1% below the QQQ stock price at the time of the trade, would in theory protect us for seven months from a big market fall that would likely hurt our ORCL, SYMC and MSFT call positions.
Then last week, the warning signs that I had been watching finally caused a minor spill, as the S&P 500 fell by 1.2% on Tuesday. I didn’t panic because we had bought protection with the QQQ put.
And while we still had the recently purchased hedge, I didn’t like the action in the market that Tuesday, so we sold our SYMC calls for a profit of 199%. I chose to sell the SYMC position because those calls were the most susceptible to a market fall and I wanted to again reduce our risk.
As the week continued, the yellow flags that I had been watching continued to concern me, so I put a mental stop on my AZN call position (which was at a profit of 100% at the time) at a profit of 50%. This mental stop would allow me to continue to let the position work higher, but with a stop, in case the market melted down.
The last several years have showed us countless times that being overexposed to one sector or another can be crushing. Oil, Biotech, Retail and many other sectors have seen intense selloffs that left overexposed investors with big losses. That’s why I recommend that you evaluate your portfolio every couple of months, figure out where you might get hurt if your investment thesis goes wrong, and hedge your portfolio with options by buying puts to protect against a sector or market decline.