Hedging Strategies for the Next Move Down

While it may seem rather inappropriate to talk about hedging strategies while the markets are retracing at least a portion of 2008’s devastating plunge, common sense continues to support the position that the worst is yet to come. Granted, focus has shifted to ‘less bad’ economic data and the anointing of government spending as the elixir that will return the American economy to prosperity. Yes, that whole “We’re going to spend our way to prosperity” mantra is once again in play. Make no mistake about it; what we are witnessing right now will be viewed years from now as the biggest sucker's rally in history – so far.

That said, now is the time to start talking about protecting portfolios from the next move down. The techniques below were used either individually or in tandem to drastically limit losses in our client portfolios during the 2008 liquidation. Some of these strategies have been sold to the investing public as ten feet tall and bulletproof, but don’t work out too well unless the intricacies are understood. And still others are exceedingly complicated to execute and rely on a preponderance of difficult predictive successes to be beneficial.

Flight to Cash and Equivalents

This move is an obvious one and constitutes either a partial or total exit from the market in question and the capitalization of whatever gains/losses existed to that point. Depending on the type of account you’re dealing with you will have a taxable event. Under many circumstances, it may be detrimental to sell out of the market. This can especially be the case if you are one of those folks who have invested in a dividend-producing portfolio and need the income from those investments for living expenses. Obviously, people in this position don’t want to see their portfolio go down in value, but can’t necessarily afford to sell those assets either. In terms of the average investor, this is undoubtedly the easiest hedge to execute with the opportunity costs being commissions, possible tax consequences, and the forfeited gains if you’re wrong.

Going Short the Market

Shorting shares and/or indexes is one way investors will choose to hedge portfolios during times when they believe markets will head lower. Let’s use the DJIA as an example. Let’s say that an extremely prescient (and lucky) trader identified the last major top in the Dow Jones on 5/19/2008 at 13,028.16. That day he shorted 100 shares of DIA at a price of $130.23 for a total of $13,023 with a $10 commission. So our trader has $13,013 in his pocket, knowing he’ll have to cover those shares at some point. Let’s assume once again that our trader gets lucky and picks the precise bottom on 3/6/2009 with the DIA at $66.23 and decides to cover. He buys 100 shares for $6,633 ($10 commission) and has $6,380 as his gain.

Obviously, this is a best-case scenario, and ironically enough, this is often how many investment ‘get-rich-quick’ schemes are presented.

The following is the flip side of shorting the market. In this scenario, our trader, having seen his brokerage account drop by 25% since the beginning of 2008 decides to short DIA on 10/22/08. He is scared to death of a further decline. He shorts 100 shares at a price of $84.59 on the DIA, pays the same $10 commission and has $8,449.00 in his pocket. Unfortunately, he has picked a short-term bottom and the market rallies substantially immediately after he takes his position and our trader is scared into covering on 11/4/08 at $95.19. Including commissions, his short position just cost him a quick $1,080 – in just 9 trading days.

With the benefit of 20/20 hindsight we can easily point out that our trader would have been much better off waiting a few more weeks to cover. He would not have lost anything, and in fact would have helped his portfolio.

The take-home point here is that shorting is not for the faint of heart. You’d best have a solid understanding of market behavior and fundamentals before even considering short-selling shares. As we learned above, the risk to the trader is unlimited. Lets say the DJIA would have gone all the way back up to its 2007 high after our trader shorted on 10/22/2008. He’d have been out over $5,700. In shorting, the rewards are finite (a stock can only go so close to zero) whereas the risks are theoretically infinite.

For the average investor, shorting shares is difficult in that you must pledge the balance of your account as collateral in case your bet goes bad. This nullifies the ‘qualified’ status of IRAs therefore IRA custodians will not extend margin privileges to IRA accounts. Standard brokerage accounts may be used to short stocks and such an account could be used to hedge other investments. While this strategy may bear occasional fruit, it is not for everyone, particularly those with short time horizons or a low appetite for risk.

Inverse Funds – Not what they’re cracked up to be?

Before beginning this segment, a few things must be said. For those who read this column regularly, you know that I rarely use specific companies or funds in these discussions, and tend to stick to sectors, fundamentals, and macroeconomic conditions. However, in this article, specific examples are going to be used to illustrate the points made and to show investors how these funds don’t always perform the way they’d expect. This is not to imply that there is an attempt to deceive on the part of the fund sponsors, but rather a misunderstanding by the investing public of the stated objectives of these funds.

Dow Jones UltraShort Profund (DXD) - The stated objective of this fund is as follows: The Fund seeks daily investment results, before fees and expenses that correspond to twice (200%) the inverse (opposite) of the daily performance of the Dow Jones Industrial Average. Let’s use a couple of hypothetical examples to illustrate how a leveraged inverse fund works. We enter our position when the DOW is at 10,000 and the price of DXD is $100/share. For the purposes of the example, we’re going to forget about the expense ratio. While the expenses must be considered, they are not necessary to make our point.

Trading Day	Dow Jones Performance (%)	DXD Performance (%)	Dow Jones Price	DXD Price
1	-2%	+4%	9800.00	$104.00
2	+2%	-4%	9996.00	$99.84
3	-3%	+6%	9696.12	$105.83
4	-2%	+4%	9502.20	$110.06
5	-5%	+10%	9027.09	$121.07
6	+4%	-8%	9388.17	$111.38
7	+3%	-6%	9669.82	$104.70
8	-4%	+8%	9283.03	$113.08
9	-5%	+10%	8818.88	$124.39
10	+4%	-8%	9171.64	$114.44

So over the course of our hypothetical 10-day trading period, the DJIA lost 8.28%. Conventional wisdom would have expected DXD to come in at a 16.57% gain. However, it only returned 14.44% (before expenses). Granted, this is not a big difference, but when you start putting it in the context of a million dollar investment you’re talking about some serious money. Now, for the sake of argument, let’s use DOG, which is the non-leveraged inverse ETF for the Dow Jones Industrial Average, and see what happens.

Trading Day	Dow Jones Performance (%)	DOG Performance (%)	Dow Jones Price	DOG Price
1	-2%	+2%	9800.00	$102.00
2	+2%	-2%	9996.00	$99.96
3	-3%	+3%	9696.12	$102.96
4	-2%	+2%	9502.20	$105.05
5	-5%	+5%	9027.09	$110.27
6	+4%	-4%	9388.17	$105.86
7	+3%	-3%	9669.82	$102.68
8	-4%	+4%	9283.03	$106.79
9	-5%	+5%	8818.88	$112.13
10	+4%	-4%	9171.64	$107.64

The performance of the non-leveraged inverse ETF wasn’t quite as bad as it netted 7.64% (before expenses) when compared to an 8.28% loss in the Dow Jones Industrials Average.

Now let’s apply a real-world example from earlier this year and watch what develops:

On February 9th, 2009, the Dow Jones Industrial Average closed at 8270.87. The Ultrashort DOW ETF (DXD) closed at $58.07 that same day. Now, shortly before close on 5/13/2009, the Dow Jones Industrials Average is at 8274.05, while DXD is at $51.33 – a difference of $6.74 from the 2/9/09 price. Conventional logic would have surmised the DXD prices would be within a few cents given the trivial difference in DOW levels. For comparison, the non-leveraged ETF (DOG) closed at $71.82 on 2/9/2009 and sits at $68.60 shortly before the close on 5/13/2009 – a difference of $3.22. Conventional logic would have also expected the price of DOG to be very similar. What is going on here?

Here’s what. It is all in the objective of the fund. Remember how it mentioned the daily performance? These funds track the index on a day-by-day basis, but as time goes on, the tracking becomes more and more sloppy. Volatility enhances this condition as was evidenced in our 10-day hypothetical study from above.

It is due to the fickle nature of mathematics that a 10% drop followed by a 10% gain doesn’t put you back where you started. This is where the inverse funds fail to protect portfolios in the longer-term. Now, if prices always moved in straight lines, the inverse funds would do fine. Obviously prices don’t behave that way. The above analysis should not be construed as an indictment of the DOG and DXD inverse funds, but rather suggests they only be used with a clear understanding of their objectives. Furthermore it must be realized that you might not get quite the level of protection you anticipated even if you’re right and the market goes down but takes a lazy path to get there.

For the average investor, inverse funds are an easy way to ‘short’ the market without actually taking the full risk of shorting. Think of it this way: if you invest in an inverse fund and the fund goes to zero, you’ve lost only your initial investment. Your actual risk is known going in. A second plus is that inverse funds may be bought in non-marginable accounts like IRAs. The major drawback, outlined above, is that you may not get the performance you expected for your buck – particularly over extended periods of time.

Using Options to Hedge Portfolios

Another potential strategy for hedging portfolios is through the use of options. We have previously discussed covered call writing for the purposes of generating income, but this week’s topic varies considerably and requires looking at things from a totally different perspective. This discussion focuses on using options for protection ONLY – not for day trading or other speculative activities. While this is not intended to be a primer on options trading and involves prerequisite knowledge, there are some important concepts that must be highlighted when using options for hedging purposes. For most average investors, hedging with options involves the purchase of put options, which can be done from many types of accounts. However, individual brokers have their own restrictions on what can and cannot be done in particular types of accounts.

Time – Options are good for a specified period of time and after such time has passed expire worthless. Even in the month (or sometimes more) before their witching (expiration), options begin to degrade in value and investors find that they’re not doing their job in terms of protecting the portfolio. Options have ‘sweet spots’ and if you’re going to use them to protect a portfolio you’d better be able to align the option’s sweet spot with the period when the market’s decline will be most dramatic. Otherwise you’re not getting the full benefit of the option and your portfolio isn’t being protected. This is no easy task by any stretch of the imagination.

Strike Price – In the case of the Dow Jones Industrials Average, put options could be purchased on DIA. If you feel the decline will last 6 months and start today, you’d look at options that expire 11/2009 or beyond. In the case of DIA, 12/2009 put options are available. Now you must decide how far you think the market will fall. Buying an option with a strike price that is too low may result in it staying out of the money in which case you might not get the full performance; especially if the decline is not as steep as you anticipated. Buy an option at a strike price that is too close to the current price of DIA and you’re going to pay a hefty premium for the option. If your prediction ends up being right that won’t be an issue, but if you are wrong, you just wasted a lot of your money.

Know Your Portfolio - A common mistake of investors who use options for hedging is that they buy the wrong option. It is imperative to understand the components of the portfolio that you’re trying to protect. For example, hedging a portfolio of junior gold mining stocks with Dow Jones Industrials Average puts is probably not a great idea. While the junior gold stocks may trace the DJIA to a certain extent there are plenty of times when such is not the case. Using a simple statistical correlation study between your portfolio’s value and the value of different market indexes can help you identify which markets your portfolio tends to track and you can then hedge more effectively.

The major benefit of buying options is that you’re taking a known level of risk. Your outlay for the option and related commissions is the extent of your risk. If you are wrong and the market moves up your option will expire worthless and you lose your initial investment only. It must be noted that this defined risk does not apply when one is writing uncovered (naked) options. These types of activities are extraordinarily risky and are highly inadvisable merely for hedging purposes.

In conclusion, there are many other factors that play into hedging and would require a dissertation to elucidate all of them to proper justice. Each investor must consider their own objectives and risk tolerance and should also consult a qualified advisor before implementing any investment strategy. The important thing to take away from this discussion is that if done properly, hedging can provide relative comfort during periods of market mayhem such as we just witnessed last year. However, if undertaken without a solid understanding of both the benefits and detriments of the hedging methodology you choose to employ, not only will you not enjoy comfort, you’re quite likely to be a regular in the antacid aisle at your local pharmacy as well.

Improper hedging techniques and use of hedging vehicles are some common mistakes investors make. Consider taking a look at our free report about 7 additional mistakes investors make – and how to avoid them. To get your copy click the following link: www.sutton-associates.net/7mistakes_report.php

Disclosures: Long DIA, GDX

Comments

[Old Trader:]

A good primer on a variety of hedging techniques available to the average investor, and the pros and cons of each, but a couple of thoughts sprang to mind as I was reading.

Perhaps I'm not typical, but I tend to view my portfolio as a whole. I look at the aggregate performance, before I start looking at the various positions, and how their individual performance has affected overall results. By using inverse ETFs to hedge a portfolio, its possible to construct a portfolio that is much less volatile than the market as a whole. I think this is especially important if one is dealing with funds earmarked for retirement. (Btw, the bulk of my investment/trading is done via IRA accounts, so as pointed out in the article, techniques such as short selling are not available). I would suggest that an average investor would be much less likely to panic and sell at the worst possible time if, because of hedges, their portfolio was relatively intact, in terms of dollar value.

I think the value of the double short ETFs lays in the fact they provide more "bang for the buck". $100k worth of DIJA only requires an outlay of $50k of DXD to hedge (assuming, of course, perfect tracking). Regarding the issue of "slippage", I'd think that could be minimized/eliminated by buying somewhat more DXD than would be theoretically required for a perfect hedge. To be honest, I'm not certain how one would go about figuring out how MUCH more should be bought to achieve the "perfect" hedge, but I also think that, aside from being an interesting intellectual exercise, and gaining cocktail party bragging rights (as well as on sites such as SA), its probably not worth the time and effort to figure out.

May 17 10:53 AM

[Fabien Hug:]

Hedging costs a lot of money. If you want to hedge your S&P portfolio for 6 months at Friday's closing prices it's going to cost you 8 % up front (given a delta of 0.455 for an at the money put). That's the cost fixed by the market and you'll not be able to do it for cheaper.
The problem is that you have to manage you option and portfolio thereafter. If, for any reason, the S&P jumps 20% next week but your hedging scenario is still deemed valid, you'll likely have to start all over again.
As explained in the article, we also know that inverse ETF do not correlate well on the long term.
So, what is left for the layman to insure one portfolio? What you can do, knowing the market's price of insurance at a given time and you time horizon; you set a stop at market price - cost of insurance. If the market drops to that level, you go into cash. Needs discipline but it's cheap. If the market goes up, contrary to your scenario, you didn't spend a buck.
Finally, if, as a private investor, you find yourself in this situation (should I hedge or not), don't forget that you are trying to time the market. This is not a situation I recommend anybody to find him/herself into (unless you have access to TARP). Your work should be much more upfront, defining an asset allocation that takes into consideration your time horizon, risk appetite and cash flow needs. After that, you can manage individual positions or sectors based on your expectations and needs (growth or dividends) and ignore market movements.

May 17 12:44 PM

[Whippet:]

Depending upon your portfolio's correlation to the S&P, the VIX is one of the best (and cheapest) hedging options out there. If you use the method presented by Jeff Augen in "The Volatility Edge in Options Trading", you can protect yourself from black swans rather comprehensively. It requires a lot of active management, however. Basically, you sell one OTM VIX puts and buy OTM calls with the proceeds- it gives you a synthetic, leveraged long VIX position. The trick is in balancing the Greeks correctly; this is not a novice play.

May 18 10:19 AM

[Hask:]

I'm definitely bearish on the dollar, especially with all the government debt being created. I have gold as a hedge and some commodity plays (UNG, RJI), but I'm looking for an efficient way to short the dollar. Anyone have experience with PowerShares DB US Dollar Index Bearish (UDN)?

May 18 10:21 AM

[Zachary Sch...:]

The "know your portfolio" section is especially important. I have spoken with plenty of investors who thought they were quite hedged only to realize that the method of hedging didn't correspond to the exposure they were taking. In the end, there is nothing more frustrating than losing money on both the hedge and the original portfolio. It is important to protect investments against loss, but the methods are sometimes more difficult than they originally appear.

Great insights,
Zach
zachstocks.com

May 18 10:59 AM

[mr clark:]

why hedge the mkt only goes up, any puts ive bought for protection this last month were $ just thrown away,.. let GS have their 10k first, BAC at 20 etc

May 18 11:10 AM

[Missing_Link:]

> To get your copy click the following link: sutton-
> associates.net/7mistak...

This link doesn't work for me ...

May 18 11:20 AM

[Missing_Link:]

What are you smoking?

The market slid 53% from October 07 to March 09 and fell 4 out of 5 days last week.

Sorry to hear you don't know how to hedge. Please don't try to turn that into a misguided take-home lesson for the rest of us.


On May 18 11:10 AM mr clark wrote:

> why hedge the mkt only goes up, any puts ive bought for protection
> this last month were $ just thrown away,.. let GS have their 10k
> first, BAC at 20 etc

May 18 11:24 AM

[aarc:]

Shorting the ES (SnP Futures) is a lot better as a hedge against the potential downturn for long stocks.

This way, I can still earn dividends from my long-term stock holds specially the financials while being able to minimize temporary drawdowns or mark-to-market paper losses.

ES or SnPFuts is a lot easier to analyze than most stocks and ETFs. The price action can also be protected with a stop loss limit during afterhours which is not possible with stocks nor ETFs.

Unlike stocks that can run up or down 10% and sometimes 20% or more in a single day depending on news affecting said stocks; ES barely moves more than 3% in a single day. You will not need so much capital since ES is leveraged needing only $2,000 deposit for $44,000 worth, more or less, the cost of 1 contract. Depending on your broker, they may require overnight maintenance margin; thus not necessarily impacting allocation of limited capital. Commision is not expensive when using on-line brokers. It costs me $2.35 per contract. Contract also expires every 3 months so will have to "renew" on or before expiration.

But then you will need a lot of technical expertise and years of experience trading ES in order to be able to find price targets as close to the tops and/or bottoms.

There are some trading rooms who specialize in the technical analysis of ES, YM and/or NQ but most of them are trend traders rather than contrarian traders.

May 18 11:57 AM

[jstratt:]

I appreciated your article.

Many investors need to consider how to hedge their portfolio for the 2nd half of 2009. If you picked up some big bargains earlier this year that you want to hold for the long term, a review of hedging strategies can help prepare the mind.

May 18 01:38 PM

[David White:]

I would tend to mostly agree with your overall assessment that the market direction should be down for the near term. The dreaded Chrysler and GM bankruptcies seem to be happening. This should cause a ripple effect throughout the economy. This should send the markets downward again. However, I am not sure I completely agree with your total gloom and doom outlook. You simply cannot ignore the fact that the government (the Treasury, the Congress, and the Fed) has been pouring money into the economy. This is going to have a salutary effect. Still I see some areas that should be due for a fall.

One particular area is the credit card business. Usually there is a salutory blip downward in charge off rates in April due to tax refunds. You did see this with COF (9.3% in Mar. and 8.56% in April). However, the charge off rates of many other companies worsened dramatically. See below:

AXP == 10.10%
BAC == 10.47%
C == 10.21%

Bottom line: the credit card businesses of most banks are worsening dramatically. Ken Lewis (CEO of BofA) has openly stated this much. The charge off rate has historically followed the unemployment rate upward. This time seems to be no exception. The prediction for the unemployment rate before the Chrysler and GM bankruptcy problems was 10.5% by the end fo this year. It is now likely higher.

A play to the downside in this area that I particularly like is oddly COF. Ignoring the April anomaly, it will liklely see quickly growing charge off rates. It will see a big deterioration in its commercial real estate business. It will see further deterioration in its residential real estate business. It tends to have a lot of higher end residential real estate. The theory is that this end hasn't been hit as hard as some fo the other real estate yet. Supposedly the richer people don't have to sell, so they are not. As we go through the worst of the downturn, this is supposed to change. You will see bigger drops in higher end home prices. This will especially hurt banks like COF, which have a high percentage of these types of loans. COF has a high exposure to the credit card business. Things are looking bleak. Plus COF has been losing money quickly of late. COF has significantly underperformed its banking compatriots. It is likely to continue to do so. It has a non-existant PE and FPE. Some or all of its profitable areas, such as the credit card business, are likely to turn unprofitable for many future quarters. This is a good short.

May 18 02:36 PM

[TucsonSpike:]

Old Trader and I are on the same page. I have been managing my investments since I sold my business and retired in 1992 at the age of 52. So here's a couple things I have learned: 1. It is more profitable to keep your high dividend stocks and ETFs and hedge them with leveraged short ETFs than it is to sell when the market turns and put the proceeds in money market. 2. You need a somewhat diversified portfolio of these short positions, not just one. 3. Get the most "bang for the buck" by utilizing the really hot leveraged ETFs, like SRS for example. 4. It is a lot easier to trade in and out of a handful of leveraged ETFs than it is to buy and then liquidate a more complex portfolio of long positions to adjust to market trend reversals.

So develop a decent timing model, be astute in your buying and selling techniques and keep making money.

May 18 06:03 PM

[Andy Sutton1:]

All,
In reseponse to 'Missing Link's' comment on the link; it must have transposed improperly when SA brought it over. Try copy/pasting the text into your browser.

Regards,
Andy Sutton

May 18 09:04 PM

[StreetMedic:]

A novel approach for one's IRA are several of the closed-ended S&P covered call funds. BEO and BEP. They have a rather splendid payout of 26 and 18% respectively at their current NAV. Both lost more than the S&P last year, but have taken off in the past 4 months.

May 18 11:21 PM

[Maxe Paul:]

Im realy not a fan of the ETF's in any guise, i would suggest using synthetic options in an IG markets account or similar product. They have small initial position sizes which you can add or subtract to whilst cost averaging into and out of a position.

May 19 08:38 AM

[optionsgirl:]

Hedging does cost money. I like to sell calls on my long positions and buy a put and sell a put on the short side, creating a straddle. That way, I defray the cost of my put protection, while making $ on the call if it expires worthless. If I am called away from my underlying position, I have taken the profit between the price I purchased the stock at, and the strike price when the stock is called away. Additionally, I keep the premium collected for that call. Or, I buy the call back and keep the position or sell it even higher.
I like this method very much. It isn't fool proof and it isn't free, but it works, and you can also do it in a retirement account.




On May 17 12:44 PM Fabien Hug wrote:

> Hedging costs a lot of money. If you want to hedge your S&P portfolio
> for 6 months at Friday's closing prices it's going to cost you 8
> % up front (given a delta of 0.455 for an at the money put). That's
> the cost fixed by the market and you'll not be able to do it for
> cheaper.
> The problem is that you have to manage you option and portfolio thereafter.
> If, for any reason, the S&P jumps 20% next week but your hedging
> scenario is still deemed valid, you'll likely have to start all over
> again.
> As explained in the article, we also know that inverse ETF do not
> correlate well on the long term.
> So, what is left for the layman to insure one portfolio? What you
> can do, knowing the market's price of insurance at a given time and
> you time horizon; you set a stop at market price - cost of insurance.
> If the market drops to that level, you go into cash. Needs discipline
> but it's cheap. If the market goes up, contrary to your scenario,
> you didn't spend a buck.
> Finally, if, as a private investor, you find yourself in this situation
> (should I hedge or not), don't forget that you are trying to time
> the market. This is not a situation I recommend anybody to find him/herself
> into (unless you have access to TARP). Your work should be much more
> upfront, defining an asset allocation that takes into consideration
> your time horizon, risk appetite and cash flow needs. After that,
> you can manage individual positions or sectors based on your expectations
> and needs (growth or dividends) and ignore market movements.

May 19 09:21 AM