Investors seeking protection in turbulent markets are getting hit with soaring hedging costs as volatility spikes amid the escalating U.S.–China trade war. Downside bets have suddenly become expensive as markets plunged earlier this week, but strategists at UBS Group AG and Credit Suisse still see relative opportunities. The relative cheapness of the Nasdaq 100’s implied volatility means investors can still find value in betting against the technology-heavy index, and they can do that by shorting the Invesco QQQ Trust Series 1 (QQQ) exchange-traded fund (ETF), according to Bloomberg.
“We still prefer the Nasdaq for hedging,” wrote UBS strategist Stuart Kaiser. Credit Suisse strategist Mandy Xu said, “While equity volatilities have been repriced significantly higher, we think there is still value in owning QQQ downside.”
What It Means for Investors
The Nasdaq 100, a market-capitalization weighted index that tracks the top 100 non-financial stocks listed on the Nasdaq stock exchange, fell 3.6% on Monday, its biggest drop since the start of the year. The index’s heavy weighting towards the technology sector makes it a favored gauge of tech stock performance, and its decline earlier in the week came as China allowed the yuan to fall in retaliation against the Trump administration’s threat to impose additional tariffs on Chinese goods.
“While the additional Trump tariffs jolted markets last week, the game changer was China’s response over the weekend by allowing the yuan to weaken above 7,” said Xu, per Bloomberg.
More declines in the Nasdaq 100 are likely as hopes of a near-term trade truce dissipate. The PowerShares QQQ ETF, which is up 22% on the year and already saw inflows double by early spring this year, not only offers investors marketable securities that track the Nasdaq 100, but offers them a way to hedge against downside risks by betting against the index through the use of stock options, specifically put options.
The spread of the Nasdaq 100’s implied volatility—a gauge of the relative cost of purchasing options—over that of the S&P 500’s was close to a year-to-date low earlier this week. Meanwhile, the CBOE Volatility Index (VIX), also known as the market’s “fear gauge,” rose 40% on Monday to its highest level since January.
Xu suggested clients use a bear put spread on the QQQ to hedge against downside in the Nasadaq 100. Put options give the owner of the put the right, but not obligation, to sell the underlying asset. A bear put spread involves buying (long) put options on a particular asset while simultaneously offsetting the cost of those options by selling (short) an equal number of put options with the same expiration date but at a lower strike price.
The difference in the strike prices minus the net costs of the options represents the strategy’s maximum potential profit. Once the QQQ drops below the strike price of the long put position, the investor begins to recoup some of the cost of that position. As soon as those costs are fully recovered, further declines represent pure profit up until the lower strike price of the short position is breached—any further gains from the long position will be offset by losses on the short position.
While the bear put strategy may help investors to hedge their portfolios against further market declines, the relative value advantage is unlikely to last forever. If the advantage really does exist, options traders looking for arbitrage opportunities will eliminate any perceived gap between options prices and fundamental values. But of course, when uncertainty is high, fundamental values are highly uncertain.