Creating a Hedge with ProShares Ultrashort QID

It is uncharacteristic for me to hedge and I rarely do it, however, I am spooked by some things that I am seeing in the general economy. I have decided to buy 100 Shares of (QID) to hedge about 10% of my portfolio against further drops in stock prices. QID shorts the highly volatile QQQ shares which replicate the Nasdaq Index.

I am not a technical analyst nor am I a market timer, but I am very concerned about another leg down in the economy and stock market over the next several months. If such a decline occurs, then this QID position will provide me with more buying power when I sell it. If it does not occur, then I will have muted the returns in the rest of my portfolio, but I think that may be a wise hedge right now.

So what has me spooked? Well as a private equity investor, I do get a bit of visibility into the "main street" economy. Of late, we have seen signs of a dramatic drop in consumer commitments for large ticket items. It could be a blip in a very small sample, but coupled with some other troubling signs it could also be the start of another leg down in consumer spending.

Additionally, I have been hearing more and more discussion in the private equity space that there is almost no liquidity for new transactions. Without lending liquidity, many of the businesses that are experiencing short-term difficulties will have no way to finance their way out of the problems.

Finally, I am concerned about another potential leg down in the housing crisis. January reached new 14 year lows for existing home sales and this general lack of credit availability is going to make it hard for the US to pull out of this downward spiral. There are also some signs that the downturn may be starting to spill over into the commercial real estate sector which would create more potential problems.

I hope that I am overreacting to this market data, but I am hedging here just in case I am not. I would never sell a large portion of my portfolio because I am a long-term investor and don't want to time myself out of a big move up. However, I think a 10% hedge is prudent here.

I really hope the Fed acts to cut interest rates again soon and add more liquidity into the system so we can see banks start lending again.

Disclosure: I own shares of QID.

Comments

[Thinkingahead]

If you think the market is going lower - sell! What do you mean you "don't want to time the market"? You already did that when you bought. Your next decision is when to time your sell. Some vague future date is an unsophisticated and dangerous way to go about that. There is nothing wrong with going to cash with a good chunk of your money, and starting again when the economy looks steady again. Remember the first rule: DON'T LOSE MONEY.

[Paulo]

Yep, things do not look good from where the private investor sits -- declining stock markets, declining house prices, declining interest rates, declining dollar and increasing inflation.
I have also used an ultrashort to hedge (not that one) and have done so for more than six months. You have to keep a constant eye on it and you will get some surprises. I also have a stop loss on it just in case things go wrong with that hedge beyond my risk tolerance level.
You might consider splitting the hedge investment between two ultrashorts, if this would provide better protection (with the idea in mind that it might also provide, given the intercorrelation of stock markets), to the international dimension of your portfolio.

[Malkiel]

I agree with Thinkingahead here: You're being illogical about how you apply your own rules. If you're a long-term investor rather than a market timer (ignoring for a moment the illusion that long-term investing is not a form of market timing), then why worry about any of this? Statistics show that the market is up 2/3 of the market days since its inception, so you run a greater risk of being trapped with QID shares when the market begins a strong upleg recovery some day. Your losses will probably wipe out any "insurance" gains if you wait for evidence of recovery to sell (advice for Paulo: don't get greedy, sell your QID now and consider yourself a lucky dog). Investors who buy discounted shares now will not be making a mistake even if there are further down legs, because they've locked in a good chunk of discount, and investors who sell now will cut off further downleg losses if that's what worries them. Calling the bottom has no science to guide us to it...

[Paulo]

Hi Malkiel -- I have already sold more than half my SDS and there is a stop loss on the rest. I need the remainder as a genuine hedge and I will settle for just getting my money back if the stock loss activates. The market is declining as I write. I need the hedge, thank you.

[sneaky]

Just remember to cover your hedge if the market turns strong against it. I put a 10% hedge with QID on Mar 2, 2007 when the market got ugly. Yeah, it worked for 2 weeks then the market turned and up and it got clobbered all the way to November. Lesson learned: Don't wait for the pain to hedge. Do hedge after your portfolio has made huge gains and you want to protect profits. When the market is making new highs and it things couldn't be better that is when you should hedge.

[Ex15:26]

A couple of thoughts on the UltraShorts and your approach to this.

1) If you've put this hedge on, you must or should have an idea of what your exit strategy point will be. (For example, you'll bail out when the Nasdaq hits 2200 or the lows of July 2006.) If not, you'll never get out and will lose it all back.

2) Remember, the QID is 2x leveraged. In this market you can be celebrating and then getting sick in the trash can in a matter of minutes. (Remember last week when the market shot up in the last 45 minutes of trading? If you didn't have a stop on it and were not at your screen, you lost all of your profits or got murdered in a matter of moments.)

3) There are tracking errors in the QID and the market. Remember the QID trades with its own supply and demand. I've had the DXD, SDS, and QID trade way off from the underlying index intra day and it can be frustrating.

4) Bottom line, you may have entered into this with the intent that you are simply going to "set it and forget it" and I think that is a mistake. Since you've already made the call to short the market you obviously have conviction that things aren't that good. Cash is really nice to have with the majority of your position and you can jump back in when the market shows that it really is moving in an upward direction (since you sound like you have an upward bias). My belief has been that we are really range bound and will retest the recent lows of 12000 on the Dow. In a range bound market you can use the QID and QLD to make money on the swings in direction. STOPS are a must!

[Paulo]

So, if there is a really big sucker's rally, you sell and buy again!!

[RichShinnick]

Why don't you go 90% to the QID and keep 10% of your long portfolio to hedge the QID investment. Maybe throw in a little SKF and SRS to diversify.

Ok, I am joking. Or, am I?

[Jan Sopoci]

Paulo,

I did the same thing with my SDS hedge, which I initiated early in Aug. 07, and exited in the big sell-off the day after MLK day. (25% up in 6 mo.) I got back in a few weeks back when SP was 1385/1390, but I DO watch it like a hawk, since it can be pretty "whippy", *G*.

[rodcore]

I have made more money with QID and SDS than I ever did going long any stock or index. Go to cash, ride the crash.

Oh and about the fed cutting interest rates to add liquidity... Clearly that isn't working... Don't you want your parents to enjoy their retirement? Allowing the fed to wratched up inflation will have them on your books and the governments books if the fed isn't careful.