The S&P 500 Index surged 29% in 2019 and started 2020 with an additional 1% rally that propelled it to new all-time highs.  Investors were seeing nothing but clear sailing with an accommodative Fed and apparent progress with China trade deal. 

Then came the missile strike killing Iran’s top general which seemed like it would certainly be a good reason for a pullback.  Now even with a looming retaliation which could potentially lead to all-out war, the market is less than one half of a percentage point off the high. To paraphrase Crocodile Dundee, “that’s not a correction!” 

No-one can pretend to know how this will play out but it seems investors are shrugging off the current situation on the fact that during past geopolitical issues, from both Iraqi invasions to the North Korea missile launches, the stock market tends to work through anything that is non-financial or directly impacts the economy.  

That said, this does create uncertainty of what happens next, which is something Wall Street doesn’t like. 

We’ll get a clearer read on the fundamentals as earnings season kicks off next week. 

But from a technical standpoint, it looks like a correction is still in the cards.

In addition, the gap open advance on January 2, followed by Friday’s decline, raises the prospect that this could become an Exhaustion Gap and a potential Island Top, that develops at the end of a price move.  

In bull markets, the strategy is to stay long equities and/or ETFs and then tactically hedge declines as soon as they begin developing.  This is done since ordinary pullbacks, like the minor one that now appears underway, can become major corrections when something unexpected happens. 

Corrections can become downturns and downturns can become bear markets when many unexpected things change medium and long-term fundamentals. Rather than waiting to see if a pullback will become a more serious downturn, I urge investors to consider hedging as soon as the first signs appear. You can think of this like buying insurance.

If the insurance is not needed, the long positions will continue higher and the insurance protection can be canceled. In addition, by watching and managing the put spread it will keep attention focused should the pullback develop into something more serious requiring, even more, put spreads. 

A prudent form of protection is selling the SPDR 500 (SPY) options. I’d look at the February expiration which will carry you through the bulk of earnings season.  Focus on the 315 strike which represents an initial support level and a modest 3% decline. 

SPY shares were trading at $323.15 per share on Tuesday afternoon, down $0.49 (-0.15%). Year-to-date, SPY has gained 0.40%, versus a 0.40% rise in the benchmark S&P 500 index during the same period.

About the Author: Option Sensei

Steve has more than 30 years of investment experience with an expertise in options trading. He’s written for TheStreet.com, Minyanville and currently for Option Sensei. Learn more about Steve’s background, along with links to his most recent articles. More...

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