Hedging Mkt Exuberance: IWM Puts > SPY Puts
Read an article in BBG today titled "Costs to Hedge the $16 Trillion S&P 500 Rally Rise Ahead of Fed." Here is an excerpt:
"Warnings of a bubble have been most loud in parts of the market riding the AI wave, where surges in Magnificent Seven megacaps, power companies, and chipmakers have delivered tidy returns all year. Instead of ditching those winners, investors have bid up protection for a marketwide downturn. That's evident in the ratio of the S&P 500 Index skew versus the single-stock skew. While the former is in the top 76% percentile of observations... the latter is in the bottom 11th percentile of readings..."
If there is a "marketwide downturn," wouldn't shares of smaller, more macro sensitive companies in the Russell get whacked relatively harder than SPY components? Is there a technical factor at play here, considering the mom and pops that may be likeliest to panic sell are overweight the SPY relative to the Russell? Is it because of a more liquid market for SPY-linked derivatives? Think this can be a productive thread for all of us trying to hedge after big gains this year....
Based on the most helpful WSO content, your observation about IWM (Russell 2000) puts potentially being a better hedge than SPY (S&P 500) puts in a market downturn is well-founded. Here's why:
Macro Sensitivity of Russell 2000:
The Russell 2000 index, which tracks smaller-cap companies, is generally more sensitive to macroeconomic conditions. These companies often have less diversified revenue streams, higher leverage, and are more exposed to rising interest rates or economic slowdowns. In a "marketwide downturn," these factors could lead to a sharper decline in IWM compared to SPY.
Investor Behavior and Panic Selling:
While SPY is a more liquid and widely held ETF, the Russell 2000's smaller-cap companies are often perceived as riskier. In times of panic, investors may disproportionately sell off these smaller-cap stocks, amplifying the downside in IWM relative to SPY.
Liquidity and Derivatives Market:
SPY-linked derivatives are indeed more liquid and widely traded, which can make SPY puts relatively more expensive due to higher demand. On the other hand, IWM puts might offer a more cost-effective hedge, especially if the implied volatility for IWM options hasn't been bid up as much as SPY options.
Skew and Tail Risk:
The excerpt you referenced highlights the disparity in skew between the S&P 500 and single stocks. This suggests that market participants are pricing in more tail risk for the broader market (SPY) than for individual stocks. However, the Russell 2000, with its higher beta and macro sensitivity, might experience even greater tail risk in a downturn, making IWM puts a potentially more effective hedge.
Hedging After Big Gains:
If your portfolio has significant exposure to the "Magnificent Seven" or other large-cap tech names driving SPY, hedging with IWM puts could provide diversification in your downside protection. This approach assumes that a marketwide downturn would hit smaller-cap stocks harder, offering a more leveraged hedge against broader market declines.
In summary, IWM puts could indeed be a more effective hedge in certain scenarios, particularly if you anticipate a sharper decline in smaller-cap stocks relative to large-cap stocks. However, the choice between IWM and SPY puts should also consider factors like your portfolio composition, risk tolerance, and the relative cost of the options.
Sources: A Decade Into IB: Teetering on the Edge of Cataclysm?, Is value investing dead?, Lack of trading and market thoughts/opinions on this site, TQQQ -- Shorting Puts (Options), Lack of trading and market thoughts/opinions on this site
My dude. Look up the vol on the two for the same expiry and delta/%moneyness and compare them.
The market is not dumb, one will be more expensive than the other….
This is quite literally the definition of "priced in"
Spoken like an asset management guy who doesn’t understand shorting or factors lol
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