The stock market is vulnerable to an 'overdue fragility event' - here's how to protect yourself

Reuters

• Stock market volatility is locked near record lows.
• Bank of America Merrill Lynch says there's never been a better time to protect against an imminent market shock.

At this point, anyone following the stock market knows that price swings are non-existent.

The CBOE Volatility Index (VIX) is locked near record low levels. The benchmark S&P 500 hasn't seen a 3% pullback in 242 days and counting, the longest such streak in history.

So what should investors do? Bank of America Merrill Lynch thinks it's time to prepare for an inevitable shock - or as it describes it, an "overdue fragility event."

And investors are in luck, because hedges against a sharp stock market selloff are the cheapest they've ever been, says BAML. The firm specifically recommends shorting one S&P 500 put contract on the benchmark falling to 2,275 by June for every two S&P 500 put contracts bet long on it to hit 2,500 by December. The index closed at 2,564.98 on Monday.

"The entry point for S&P 'fragility hedges' in the form of put ratio calendars has never been more attractive," BAML analyst Nikolay Angeloff wrote in a client note. "This is a trade worth considering if you disagree with the market's implied belief that risk does not exist."

The attractiveness of the entry point comes from the steepness of the S&P 500's term structure, where near-dated contracts are expensive relative to those further in the future. Further, put skew - or the degree to which future protection is more expensive than at-the-money options - is high because of the market's tendency to buy more stock exposure on short-term dips.

You can see that dynamic at play in the chart below.

So why not throw some protection on? It's cheap, and if the market sees a downturn, you'll be glad you did.

Bank of America Merrill Lynch