Q4 Letter to Shareholders: How will the market end in 2023
Hedging risks means effectively protecting investments from major downside losses. One strategy to hedge risks is to use spreads.
24Hour Shareholders —
Quarter 3 of 2023 has been correctional compared to the year's first half. Not only have many stocks and indices lowered their valuations, but the macroeconomy is still being determined. Rising oil prices are spilling through the economy and keeping consumer prices elevated as businesses deal with higher energy costs. While inflation has drastically slowed, the Consumer Price Index (CPI) still stands at 3.7% (+0.5% higher than the previous year). CPI is a measure of inflation calculated by the Bureau of Labor Statistics (BLS) by surveying the prices of a basket of goods and services that urban consumers purchase.
The Federal funds rate -- the rate at which the Central bank loans money to other banks -- is 5.25%-5.50%. These once-in-a-generation rates are believed to be near the top of monetary forecasts and have made the cost of borrowing money for houses, cars, business loans, and other discretionary and non-discretionary items so expensive that many analysts are pointing to the 2008 Great Recession to put into perspective where we are today.
Let's take a closer look at three ETFs that track the major indices and see where traders are hedging towards the end of the year.
Catch up and read July’s mid-year market analysis
UPDATE: Mid-Year Market Outcome
SPY, SPDR S&P 500 ETF Trust
As of the close of the market on September 29, SPY closed at $427.40. SPY SPY 0.00%↑ is the original and oldest ETF that tracks the S&P 500 index, or the 500 most valuable US companies. Observing the options market, the chart below indicates that the current price of SPY will waver right around where it is today. Bullish traders, those placing option calls where they believe the price of SPY will rise towards $460 at the end of the year, are met equally by bearish traders that are hedging that SPY will end the year closer to $400. Open Int, or Open Interest, indicates the amount of interest at a particular price or strike price.
There are tens of thousands of contracts (and at the strike price of $400, there are over 100K contracts) between the price range of $400-460 where buyers and sellers try to make deals. One takeaway from observing this activity for SPY is there is significantly more activity and interest in the S&P 500 than in the two other major indices, as you will see below.
*A savvy observer will ask: why is the date of January 19, 2024, on the chart, even though you are talking about how these ETFs will end in 2023? The option expiration date ending on December 15, 2023, does not have enough activity to warrant any meaningful information. So, by extending the expiration date until January 19, more meaningful information can be analyzed and interpreted.
QQQ, Invesco QQQ Trust Series 1
At the close of the market on September 29 for quarter 3, QQQ closed at $358.27, nearly the same price as when it started the quarter. Similar to SPY, QQQ QQQ 0.00%↑ has a balance of bullish and bearish hedges and maybe a slight advantage towards the bearish hedges. QQQ is an ETF that tracks the tech-heavy NASDAQ index, which has had a meteoric rise since January 1 and certainly has converted more people into millionaires.
The Put side of the chart -- the bearish side where traders are hedging for the price of QQQ to land at a strike price between $340-$355 -- does carry more Open Int activity than the bullish Call side. However, because tech stocks often have more significant price swings, the difference between the price at market close and the strike price range of $340-$370 can be re-balanced within a few days. In other words, the risk in a QQQ play is minimal because it may only take a few days to recover any losses.
DIA, SPDR Dow Jones Industrial Average ETF Trust
DIA DIA 0.00%↑ closed quarter 3 on September 29 at $334.90. Perhaps the most surprising data of the three major indices, DIA, which tracks the Dow Jones index or the 30 most valuable US companies, hovers at a price slightly above where the year started when it opened at $332. Like QQQ, there is a slight advantage in the amount of Open Int on the Put side, but not by much. Between the strike price of $330-$350, this type of swing can occur in just a few days, and as such, the risk is relatively low compared to SPY.
Practice, practice, practice
After reviewing where traders are hedging based on the options market, the probability of volatility to the end of the year is relatively low. Perhaps the most adversarial event that could change the winds would be any escalation of geopolitics, particularly the Russian-Ukraine War. With that in mind, here is a particular investing strategy that applies to trading and making good financial decisions.
Hedging risks means effectively protecting investments from major downside losses. One strategy to hedge risks is to use spreads. A spread is the difference between two prices or values. In the world of ETFs, there are leveraged or bullish ETFs and inverse or bearish ETFs. Two of the most actively traded ETFs are TQQQ (3x-leveraged) and SQQQ (3x-inverse). Both are indexed to the NASDAQ, and when the NASDAQ returns 1% for the day, TQQQ returns 3%, and SQQQ returns -3%.
A bullish spread to protect your investment from major downside risk would be to put 60% of your investment in TQQQ and 40% in SQQQ. On the flip side, a bearish spread would be to put 60% into SQQQ and 40% into TQQQ.
The gains or losses may not be meaningful, but the strategy is to protect your investment from major downside losses. Due to the expected market conditions with no exponential growth or fall-off-a-cliff decline, practice using spreads to protect your investment. This strategy will help in investments in the market and in making any financial decisions like what car to buy or which country to travel to.
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