Looking for a hedge? Consider short-term long put options or volatility trades aimed at protecting stocks from unexpected economic results.
Some of the stock market’s biggest moves come after economic reports. One fan favorite is the non-farm payrolls and unemployment report, which is issued the first Friday of each month. While economists and market-watchers routinely follow these releases, some traders will trade the numbers. As part of that approach, the options market might offer a degree of protection in anticipation of report bombshells—proving that sometimes a short-sighted focus simply positions you to trade another day.
One-off events like major economic reports aren’t always a straightforward trade. One options approach might be aimed at protecting stock holdings from unexpected swings. Another aims for potential profit from the ensuing market volatility. That begs a two-part question: How will the market react to the economic numbers, and which approach best fits your trading strategy?
For our purposes here, I’ll focus on ways to create short-term protection in the event the market’s reaction to the report doesn’t go your way.
Let’s say U.S. payrolls swelled by 500,000 jobs in a given month. On the one hand, adding so many jobs might be great for the economy and presumably bullish for the market. But if the Federal Reserve determines this job growth is too aggressive, they might respond with more aggressive interest rate policy, and that makes the stock market nervous. Wall Street starts to perspire with concern that the Fed could overshoot and cool growth. If a too-hot report surprises the market, you’ll likely see a negative reaction in equities. The opposite is true, too. Since job growth fuels spending, overly weak numbers aren’t too bullish for stocks, either.
Assume you’re a long-term investor who might routinely use short-term long put options for portfolio protection. During bullish periods when the economy is buzzing along at a merry rate, the market doesn’t pay a whole lot of attention to the numbers. But when jobs data dominates the headlines, it may be time to take some action.
So here’s how you might prepare. When market watchers begin emphasizing the release of the jobs report, some traders will consider adding short-term long put options to their portfolios, just in case the market doesn’t like what it gets. If equities tank, you’ll likely be glad you took action. Now, of course, if stocks end up rallying, the puts you bought will likely cost you, and you must accept that risk. However, you can always try to sell them.
Or, you can even potentially sell an out-of-the-money (OTM) call spread, using the credit from the sale to offset some of your long put option costs (figure 1).
FIGURE 1: WEIGH THE RISKS. The profit/loss graph of a simulated long equity portfolio, with long out-of-the-money puts for protection and out-of-the-money call spreads sold to offset the cost of the puts. For illustrated purposes only. Past performance does not guarantee future results.
Another way to prepare for the release of economic news is by potentially trading options on volatility-based products including the CBOE Volatility Index (VIX).
If either the unemployment reading or non-farm payrolls disappoints, volatility will likely rise as equity markets sell off. And if that’s the case, VIX call options can rise, making ownership of these calls a means of limited, short-term protection against a falling stock market.
As with the long put option method, if the market moves higher (or doesn’t really move anywhere), one might expect volatility to drop, and long call options on the VIX would likely lose. So, be prepared for the risk.
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