Strategists up and down Wall Street are bullish on stocks through the end of next year, and a big part of that stems from optimism around tax reform. But by that same token, if policy progress fails to materialize, that could spark a considerable sell off in equities.
Luckily, market conditions are shaping up to give traders an inexpensive way to hedge against this potential loss, says Goldman Sachs.
The firm's derivatives strategy team has concocted a trade known as a put spread: Buy a specific number of S&P 500 contracts expiring in February with a strike price of 2,525, while selling the same number of February puts with a strike price of 2,400.
For reference, bearish put spreads are used when a moderate decline in the underlying asset is expected — in this case, Goldman's trade will be "in the money" about 5% below the S&P 500's current level.
"Failure of tax reform is enough of a short-term possibility that it is worth hedging," Rocky Fishman, an equity derivatives strategist at Goldman Sachs, said in a client note. "With the S&P 500 within 1% of its high, we believe prudent investors should take advantage of low option prices to hedge."
So what makes this particular trade so attractively priced? Goldman attributes it to historically low volatility and high skew, the latter of which reflects the willingness of investors to pay a premium for calls. The combination of the two factors "gives put spreads materially higher payout multiples than they usually have," says Fishman.
Market conditions are shaping up to make it cheap to buy S&P 500 hedges to protect against tax reform failure.Goldman Sachs
Lastly, Goldman stresses that buying the put spread is the best way to hedge against tax reform downside, rather than simply holding money on the sidelines. This is both because the options are cheap right now, and because it provides better outcomes in a wider range of market scenarios.
"Prudent investors should own stocks and hedge with put spreads instead of running high cash balances," said Fishman.