The combined effects of rising inflation and slower growth — a trend commonly known as “stagflation,” or stagnant growth with inflation — has been top of mind in recent months and has become the No. 1 fear in the U.S.

That’s not surprising, as stagflation has the greatest impact on U.S. consumers, who represent 65% of that country’s gross domestic product, and is impervious to action from the U.S. Federal Reserve Board. Raising rates to quell inflation slows down an already slow economy; cutting rates to stimulate economic activity fuels inflation.

Based on CIBC World Markets Inc. research, the Toronto Stock Exchange is more correlated to global growth than is the New York Stock Exchange, owing to the TSX’s heavy resources weighting.

Relatively speaking, the TSX 60 index is better positioned than the S&P 500 composite to weather the twin storms of deteriorating growth and rising inflationary pressures, mainly because global demand for commodities remains favourable.

Assuming you buy into the stagflation argument, one strategy to consider is what I like to call the “stagflation-neutral hedge.” This strategy serves a couple of purposes: it allows us to look at this environment as a hedge fund would; and it allows me to present some math that advisors can talk about with any type of hedging strategy.

The stagflation-neutral hedge seeks to take advantage of performance gaps between the TSX 60 (XIU) and S&P 500 (SPY). In a classic hedge fund approach, you would buy XIU and short SPY. The options traders basic version of the stagflation-neutral hedge is to buy calls on XIU and sell calls on SPY.

However, I have three concerns with the basic approach: the sale of an uncovered call is an unlimited-risk trade; the purchase of XIU calls against the sale of SPY calls is not an offsetting position, in terms of margin requirements; and XIU and SPY have different prices, which requires some mathematical input to create a neutral hedged strategy.

The easiest way for me to deal with this is to utilize a bear call spread on SPY, which effectively limits the risk should the U.S. market rally.

As an example, with SPY at US$128 at the time of writing, one could write (sell) the SPY December 128 calls at US$6.50 while buying the SPY Dec 138 calls at US$2.25. The net credit from the SPY bear call spread is US$4.25.

The other side of this trade is to buy calls on XIU. With the four-for-one split on XIU shares, one might consider buying the XIU Dec 20 calls at $1.30.

Before moving to the mathematical implications, we should define the margin issues. As mentioned, this hedge strategy is not an offsetting position, in terms of margin requirements. You must pay in full for the XIU options and must post margin on the SPY bear call spread. The margin would be the difference in strike prices (US$138 minus US$128 = US$10) less the premium received (US$4.25), which equals US$5.75 a share (US$575 per spread).

Now, to the mathematical implications. The first consideration is the difference in the price of XIU ($20.16) vs SPY (US$128). Leaving aside the exchange rate, a neutral strategy would require the purchase of approximately 640 shares of XIU against the sale of 100 shares of SPY. From an options perspective, one would buy six XIU calls for every SPY call.

However, since we do not want to run the risk of an uncovered call position, the bear call spread concept requires some further calculations based on the delta of the two SPY options. One way to look at delta is in terms of an equivalent share position (ESP).

The short SPY Dec 128 call has a delta of 0.56. A delta of 0.56 implies an ESP of 56, which is to say, a short SPY Dec 128 call has about the same risk characteristics as being short 56 shares of SPY.

The long SPY Dec 138 call has a delta of 0.23, implying an ESP of 23 shares. In other words, the long SPY Dec 138 call carries about the same risk as being long 23 shares of SPY. As a net position, the short SPY Dec 128/long Dec 138 bear call spread has the equivalent risk of being short -33 shares of SPY (-56 ESP from the short SPY Dec 128 call, +23 ESP from the long SPY Dec 138 call = -33 ESP).

@page_break@Now, bring the two pieces together. Each XIU call purchased has an approximate underlying exposure of $2,016. That is based simply on the value of XIU at the time of writing multiplied by 100 (the shares exposure of each call option contract — i.e., XIU at $20.16 x 100 shares per call = $2,016).

Each SPY bear call spread has the equivalent dollar risk of being short -33 shares of SPY at a price of US$128, or approximately US$4,224. Based on those approximations, a neutral hedge would require you to buy two XIU calls for every SPY bear call spread.

This hedged trade creates a credit from the sale of one SPY spread of US$4.25 (US$425 per contract) vs a cost of $2.70 ($270 per contract) for the two XIU calls purchased. The margin requirement for this complete position is $270 for the two XIU calls plus US$575 per SPY bear call spread.

If the U.S. market declines as fears of stagflation mount, this strategy will profit if the Canadian market does not fall as fast.

This strategy also profits if the markets stay the same through to the December expiration. In that scenario, the XIU calls will expire worthless, but you would retain most of the premium from the SPY bear call spread.

If the U.S. markets rises substantially, it should drag the Canadian market with it. Which means that profits from the XIU calls should offset losses on the SPY bear call spread.

The real risk is that the U.S. market will rally while the Canadian market slips — a position that has occurred regularly over the past few months, although most of the upside performance of the U.S. stock market can be explained by diminished inflationary expectations as speculative influences in the oil market have waned.

That’s very different than oil prices being dragged lower on the back of a more serious U.S. recession or stagflation. Assuming stagflation occurs — the premise for this strategy — it seems unlikely that the U.S. market would rise while the Canadian market falls. IE