Sudden Market Crash Triggered by Trump's Tariff Threat: A Guide to Hedging with Put Options

On October 10, the U.S. market experienced a significant crash, with the Nasdaq Index plummeting 3.56% — its largest single-day drop since April. The S&P 500 and Dow Jones also fell sharply by 2.71% and 1.9% respectively. This abrupt decline was primarily triggered by renewed trade war fears, but also reflected deeper vulnerabilities in market structure after a prolonged rally.

(1) Direct trigger: Escalation of Sino-U.S. tariff conflicts, with the White House threatening to impose new tariffs on China. Recent developments in trade negotiations and the specific implementation of tariff policies.

(2) Market valuation factors: Previously leading sectors with high valuations, such as semiconductors, electric vehicles, quantum computing, and nuclear power, were hit hard, showing a significant valuation correction effect. Furthermore, with the upcoming Q3 corporate earnings reports (especially from tech giants), concerns about whether earnings can support the current excessively high valuations also triggered risk-off trading.

(3) Market macro factors: After the September FOMC meeting, the market had already priced in expectations for three rate cuts this year. The resurgence of the tariff war raised concerns about economic recession, declining consumer confidence, and the potential long-tail inflation effect from the tariff war hindering the Fed's rate cut process, leading to decreased market risk appetite.

(4) Gray rhino risks: The ongoing shutdown of the U.S. federal government; geopolitical tensions; global debt risks, etc.

Cautious camp: Analysts represented by JPMorgan Chase CEO Jamie Dimon believe the risk of a severe stock market decline within the next 6 to 24 months is very high. He is concerned about uncertainties brought by overheating AI investments, geopolitical risks, and fiscal spending issues. Additionally, some analysts believe that if the U.S. economy falls into a recession, the S&P 500 index could face a significant correction.

Optimistic camp: Saira Malik, Chief Investment Officer at Nuveen Asset Management, points out that robust corporate profits, especially from tech giants, will continue to support the stock market. James St. Aubin of Ocean Park Asset Management also believes that trade tensions will not shake the core artificial intelligence (AI) theme driving the market.

The abruptness of the October 10 decline, a straight-down plunge during trading hours, meant many investors had no opportunity to reduce exposure before sustaining significant losses. For investors who were caught off guard by the sudden market downturn, put options offer an efficient method to quickly hedge portfolio risk without liquidating positions.

When choosing put options for hedging purposes, three key parameters must be considered:

– Expiration: Opt for 1-2 month terms to balance time value decay with sufficient coverage during the volatile period.

– Strike Price: Select at-the-money or slightly out-of-the-money puts with deltas between -0.3 and -0.4. This provides a cost-effective balance between protection level and premium outlay.

For example, following the decline, an investor might choose SPX puts expiring in November 21, with a strike price of 6400 to protect a diversified portfolio.

Hedging approaches range from full protection to partial coverage:

– Full Hedging: Completely offsets portfolio losses during market declines

– Partial Hedging: Provides limited protection while reducing premium costs

The formula for determining the number of put option contracts needed for full hedging is:

Number of Contracts = (Portfolio Value × Portfolio Beta) / (Option's Effective Leverage Ratio) / (Option Price × Contract Multiplier)

Consider this illustration: an investor with $500,000 equity portfolio, the beta is 1.5

– the SPX put option @6400 expiring on Nov. 21 has an effective leverage ratio of -18.45, priced at $97.99

– Standard contract multiplier for this SPX put options is 100

Contracts Required = ($500,000 × 1.5) / 18.45 / ($97.99 × 100) ≈ 4.15 contracts

An investor would round to 4 contracts for full hedging, or fewer for partial hedging based on their market outlook and risk tolerance.

The advantage of a Partial Hedging is that it would not cause the investor to miss out on the potential market rise meanwhile providing increasing fall protection when the market moves downwards.

Under a partial hedge, if the market rises modestly, the investor's profit will be lower than the market gain. If the market falls modestly, the investor's loss will be lower than the market decline. And if the market falls significantly (e.g.,>5%), the put options provide substantial protection, potentially preventing losses or even generating a small profit.

Investors can decide the number of option contracts for hedging based on their judgment of the market trend. If they are not sufficiently confident about further future declines, they can initially use partial hedging for some position protection. If the market declines further later, they can increase the number of hedging contracts. Conversely, if the market stabilizes and stops falling, they can gradually close out the option hedging positions.