As this year's "Santa Claus rally" reaches its halfway point (the first four of the seven trading days), investors hoping for another year-end rally in U.S. stocks have been notably disappointed. While the first two days of the rally saw markets climb, Friday and Monday brought consecutive losses of more than 1%.
This lackluster performance in the latter half of December has caused the S&P 500 to tumble from its position as the best-performing index this century to fifth place in terms of annual returns.
Goldman Sachs trader and Managing Director Nelson Armbrust outlined several bearish factors in a report on Monday. He emphasized that his top trading recommendation was to “buy put spreads to approximate Tuesday's hedged portfolio length.”
Gamma Volatility
On Tuesday, a significant number of options contracts with strikes between 6050 and 6070 are set to expire, creating a highly volatile gamma environment. Currently, the market holds over $3 billion in long positions. A 1% market increase would push this gamma exposure to over $7 billion in long positions, while a 1% decrease would balance out these $3 billion holdings.
Pension Fund Rebalancing
Goldman's latest estimates suggest U.S. pension funds will sell $27 million in equities as part of their rebalancing—a figure larger than 87% of past rebalancing periods. However, the report cautions that pension funds are not obligated to rebalance and may choose how and when to do so. Historically, markets indicate that pension funds begin rebalancing a day or two in advance. Last Friday’s sell-off amid rising Treasury yields was a strong indicator that rebalancing is already underway. Moreover, the $3.9 billion in market-on-close (MOC) orders on Friday echoed patterns of early rebalancing activity.
Armbrust concluded:
“Headwinds outweigh tailwinds over the next two days. I recommend buying S&P put spreads to align with Tuesday’s hedged portfolio length.”
Why Bear Spreads?
As Armbrust highlighted, if an investor seeks a hedging or bearish strategy, the bear spread is an ideal choice.
What Is a Bear Spread?
A bear spread is an options strategy used when a trader expects the underlying asset's price to decline in the future. It allows the trader to short the asset while capping risk within a defined range. Bear spreads can be constructed with either calls or puts:
Bear Call Spread: Involves selling a call option at one strike price while buying another call option at a higher strike price.
Bear Put Spread: Involves buying a put option at one strike price and selling another put option at a lower strike price.
For example:
Bear Call Spread: Buy a call option at a specific strike price and sell a call option at a lower strike price, both with the same expiration date.
Bear Put Spread: Buy a put option at a specific strike price and sell a put option at a lower strike price, both with the same expiration date.
Key Advantages
Bear spreads reduce shorting risk. For instance, selling stocks outright carries unlimited theoretical risk if the stock price rises. In contrast, using bear call spreads significantly limits this risk. Additionally, variations such as calendar spreads can be achieved by combining options with different expiration dates.
Bear Spread Example with Volatility Instruments
The S&P 500 Volatility Index (VIX)—nicknamed the "fear index"—is theoretically a percentage-based metric (usually between 15-25, with extremes ranging from 9 to 80). It reflects the implied volatility of S&P 500 options over the next 30 days.
The 1.5x Long VIX Short-Term Futures ETF (UVXY) leverages the VIX index by 1.5 times, meaning a 10% VIX rise corresponds to a 15% UVXY gain (theoretically).
Constructing a Bear Spread on UVXY:
Suppose $ProShares Ultra VIX Short-Term Futures ETF(UVXY)$ trades around $20.90 in pre-market, and an investor expects it to drop to $18 within a month. The bear spread could be constructed as follows:
Sell a February 7 call option with an $18 strike price, earning $330.
2.Buy a February 7 call option with a $30 strike price, costing $165.
This establishes a bear spread with a capped maximum profit when UVXY drops to $18 and limited maximum loss due to the higher-strike call.
Conclusion
The bear call spread is ideal for investors expecting neutral-to-bearish conditions while desiring to limit risk. Also called a "credit call spread," this strategy profits from time decay and declining prices.
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