Looking to Q3 2012

by Jay Pestrichelli on June 29th, 2012

As the quarter comes to an end, the market got a much-needed injection of optimism. In the face of weak consumer spending numbers and the lowest sentiment numbers of the year, the market is riding high on Europe’s focus of lowering the borrowing costs for Spain and Italy. Despite the Q2’s choppiness, overall trend continues to be up with higher highs and higher lows, although the now dreaded August is still to be traversed.  Believe it or not, trend viewers would say we’re right in the middle of the range and testing the lower half is still very possible in the next few months.
In the past August was a boring month. But ever since 2007 it has ended up being one of the most volatile. Up days like we’re seeing today, June 29th, provide an excellent opportunity to establish protection through the rest of the year. For those of you that have yet to follow rule #1 and hedge every investment, consider putting in some “catastrophe” insurance today. Looking at our chart above, the 1220 level seems to be the lower end of the trend for August. Here are some put quotes to get an idea of the cost by month it would take to establish protection and the probability of the market closing below that level by expiration.

• Sep (2.5 moths) 1220: $15 (~5.3% annualized) 12% Probability
• Oct (3.5 months) 1225: $23 (~5.8% annualized) 16% Probability
• Dec (5.5 months) 1220: $37 (~6.0% annualized) 22% Probability

We are seeing one of those situations where short-term protection is cheaper than long term and if our biggest concern is August, September works out to provide coverage through the right time period.

Going a little lower on the strike price down to 1175 (~13% decline from today’s prices) will lower the costs and probabilities are basically cut in half.

• Sep (2.5 moths) 1220:  $10 (~3.6% annualized) 6% Probability
• Oct (3.5 months) 1225: $16 (~4.1% annualized) 8% Probability
• Dec (5.5 months) 1220: $29 (~4.7% annualized) 14% Probability

When we see costs per day being more expensive the farther out we go in time, it tells us the market is less than confident about the uptrend and they will make us pay more for the insurance. This again brings up a key decision, which is how long to we want the put to provide protection. If we’re more concerned about August than December, consider the shorter period September as a way to provide some broad-based protection.

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