Back in the summer, EVERYONE said we were going to break out to new highs and the analysts were tripping over themselves to predict a higher goal for the S&P and, after calling for caution since May, I virtually screamed for people to get to cash on July 20th in "Monday Market Manipulation - Everything is Awesome" in which I said:
CASH!!! People! Cash, cash, Cash and more CASH!!! I can only tell you and show you that the conditions we are seeing now - INCLUDING the market-boosting government bailouts - are VERY similar to what happened in 2007/8 leading up to the collapse. That is the limit of my ability. In 2007 and early 2008 I also was "wrong" and the markets went up and I said it was ridiculous and the markets went up and I warned people to go to cash and the markets went up and my only regret was that I didn't do MORE to warn people how dangerous the markets were at the time.
Fortunately, we followed our own advice and cashed in our Member portfolios - getting out at the red line on our Big Chart (+15%) and getting back in at the green line (Must Hold) and THAT is why we have AVERAGE gains of over 100% since last summer - especially as we did it all over again in November! Our timing could not have been better. PERHAPS this time is different but I have that same sense of foreboding I had in July but not so imminent that we've gone to all cash - but we do have $120,000 worth of downside hedges in our Short-Term Portfolio and we did tightly cover our Long-Term, Butterfly and Option Opportunity Portfolios (see weekend review).
In fact, we gained about $8,000 (1.3%) in our paired Long and Short-Term Portfolios on yesterday's little dip so I think we're bearish enough there but the OOP lose $2,000 (2%) and the Butterfly Portfolio, God bless it, was flat (it's supposed to be). Portfolio balance is a tricky thing and it's important, when you are worried about market direction - to have a very good idea of how a 1% rise or fall will affect your overall balance.
If it all goes to Hell this evening, it will be Apple (NASDAQ:AAPL)'s fault so it makes sense for us to add an Ultra-Short Nasdaq ETF (NASDAQ:SQQQ) hedge that will pay us $15,000 in the STP, to offset some of the losses on the longs we haven't sold yet. Given that our immediate concern is a poor report from AAPL (and if there is one, we'll be buying that dip!) we can take a short-term cover in our STP for earnings season:
- Buy 40 June SQQQ $17 calls for $2 ($8,000)
- Sell 40 June SQQQ $21 calls for 0.85 ($3,400)
- Sell 5 AAPL 2018 $85 puts for $7 ($3,500)
Consider how this hedge works. If AAPL has bad earnings, the stock drops but probably not 20% (now $105) and the short puts would be safe while the Nasdaq falls with AAPL (it's over 10% of the Nasdaq) and SQQQ (now $18.45) will shoot higher and we should be $4 in the money, collecting $16,000 on our spread.
We will be obligated to buy 500 shares of AAPL at $85 ($42,500) but we want to do that anyway (now $52,500 at $105). Less the net $14,900 we collect on the hedge, our net entry on AAPL would be $27,600 or $55.20 per share. If owning Apple at 50% less than it's trading today does not appeal to you - this isn't a hedge to make!
If, on the other hand, AAPL has great earnings then it will go up and the Nasdaq will go up and SQQQ will go down but all we can lose on the spread in that case is the net $1,100 cash we are putting in - that's the cost of our insurance into earnings uncertainty and, considering we have 1,000 shares of Apple options to protect in our LTP and another 500 in the Butterfly Portfolio - it's well worth it!
Like any insurance policy, hedges should be tailored to your needs but you won't know what you need unless you measure your portfolio and BALANCE your positions - so you'll know exactly what effect you can expect - BEFORE it happens. Knowing things before they happen is far, far better than being shocked by everything that happens - try it and you'll see what I mean!
The reason it's a good time to go short on the Nasdaq is because the chance of being burned to the upside, over the 5,000 line (up 105 points), is a lot less than the chance of being rewarded with a 10% dip back to 4,500 (down 395 points). As you can see from the chart below, we're right at the 50-day moving average at 4,882 into AAPL's earnings this evening and 5,000 is a full 25% over our Nasdaq Must Hold line on the Big Chart at 4,000.
There's an argument to be made that we should have rebalanced the Must Hold line on the Nasdaq to 4,400 due to the Nasdaq rebalance a year ago. If we did, the Nasdaq would be up 15% and in-line with the S&P. We didn't do that, we're using the same lines we've been using since late 2013 and, if we do break higher, we'll be redoing the lines but I'm still waiting (year 4) for a real breakout that convinces me we should recalculate.
As recently as Jan 14th, we decided fair value for the Dow was 17,600 (our Must Hold Line), which was up 10% from where we were at the time. The Dow is flirting with our shorting line at 18,000 now but it's not uncomfortably high - more of a technical pullback at this spot but AAPL is also a Dow component now, so things can get very interesting there as well. Before the Dow, our last major index valuation was on Aug 13th, when we took on the S&P and, at the time, we decided to short it at 2,100 for a 10% correction (and that was a $10,500 profit on short /ES futures contracts a week later!).
I'm not making any drastic calls now - just urging caution into all this uncertainty. We make $8,000 yesterday in our paired portfolios and we should put $3,000 of it into hedges - so maybe we'll do 100 of the SQQQ spreads instead of 40. As a rule of thumb, when we're sitting on a rally like this, about 1/3 of our profits should be put back into 2:1 or better hedges to lock in our gains.
In other words - be careful out there!
Disclosure: I am/we are long AAPL, SQQQ, TZA, SDS, LL, UNG.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Positions as indicated but subject to RAPIDLY change (currently mainly cash and an otherwise slightly bearish mix of long and short positions - see previous posts for other trade ideas). Positions mentioned here have been previously discussed at www.Philstockworld.com - a Membership site teaching winning stock, options & futures trading, portfolio management skills and income-producing strategies to investors like you.