Trading at the beginning of last week saw the Dow and S&P 500 lose about 3.5% and 4%, respectively, while the three days of trading leading to Wednesday’s lows saw the Nasdaq decline over 5%. Broad market declines were, at the time, attributed to a spillover from tech-heavy growth stocks (the Nasdaq was off nearly 8% from YTD highs) as well as increasing fears around inflation. Fortunately, stocks rebounded at the end of the week and offset the majority of those losses. That brief sell-off was enough to spook plenty of investors and raise questions about using a long-term options strategy to maintain a bullish position while muting the impact of short-term volatility.
There’s no doubt we’re still enjoying a bull market for equities in general (tech may be a different story, but we’ll get to that later). As you can see from the chart below, the S&P 500 is showing classic technically bullish behaviors.
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Throughout the last six months, the S&P has persistently set higher highs and higher lows. Additionally, it’s generally finding short-term support at its (rising) 20-day line and even when it breaks that support it’s testing or finding new support at the more intermediate-term 50-day line (the blue line above). Couple that with normal-volume trading and you’re seeing a very typical bull market.
Investors implementing a long-term options strategy could purchase an at- or near-the-money January 2022 call on the SPDR S&P 500 ETF (SPY) for around $23, approximately 5% of the cost of the underlying investment.
A Cost-Mitigating Long-Term Options Strategy
We’ve written before about the risk mitigation aspects of using LEAPS (long-term equity anticipation securities) for a long-term options strategy, but there are also cost mitigation strategies you can implement. For instance, you could currently sell an out-of-the-money SPY call (against the underlying LEAP) with an expiration next month for $3-$5 (depending on how far out-of-the-money you’re planning to go).
In the event a bull market enters consolidation or becomes range-bound, selling out-of-the-money calls against an underlying call position can allow you to reduce your effective cost of the LEAPS contract. However, in the event that the bull market resumes prior to the expiration of the calls you’ve sold, you may be forced to buy those calls back to avoid having to exercise your underlying calls prior to their natural expiration. This typically won’t generate losses on the trade as your in-the-money LEAPS should have appreciated at the same rate as the now-in-the-money calls you’ve sold.
This type of bull call spread, where you have a mismatch in expiration months, is known as a diagonal spread, and is a frequently used long-term options strategy.
Now, contrary to the bull market we’re seeing reflected in the S&P 500, the Nasdaq is currently trading sideways, having touched resistance in mid-February and then again at the end of April. While the rising lows in the Nasdaq (early-March, end of March, mid-May) are bullish, rising lows alone are not predictive. As you can see in the chart above, we saw a bearish cross (by the red 20-day line) over the 50-day line in March which was followed by a bullish cross later in April.
Ideally, we’ll see the moving averages and index values converge, followed by a bullish move by the Nasdaq above its averages which could then lead to a re-testing of that previously established resistance level right around 14,100. Should this consolidation be the end of the previous bull market, we’d expect to see the convergence result in high selling pressure and a breakdown below previously rising lows.
A Speculative Long-Term Options Strategy
LEAPS investors could engage in a speculative long-term options strategy by buying calls above the resistance level (if they’re bullish) or by buying puts at or below the level at which the Nasdaq is trading now (which appears to be near the previously discussed convergence point). For the bullish investor, LEAPS offering exposure to the Invesco QQQ Trust (QQQ) above 340 (the price which coincides with that resistance in the Nasdaq) with a January 2022 expiration are trading near $16, again, approximately 5% of the cost of the underlying investment.
Using LEAPS as part of a long-term options investing strategy can be an effective tool for managing short-term volatility either by reducing your costs, or by looking forward to significant price levels while also offering downside protection.
Is this consolidation in the Nasdaq signaling the end of tech’s current bull market?