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Now would be a good time to start hedging. With major indexes hitting multi-year highs, and the VIX at a 52 week low, conditions are right. The best time to buy insurance is when there is no immediate peril in sight. Equity investors in the aggregate have put concerns for the European debt crisis, China slowdown, and fiscal cliff on hold. These issues are likely to return, perhaps with a vengeance.

The Market

Most investors, if asked, would tell you that the "market" is the S&P 500 (NYSEARCA:SPY): to beat the market, one must beat the index. Of course there are many indexes. At the same time, the word sometimes refers to investors in the aggregate: "the market is nervous."

The market is also a place, or a group of places, some of them physical, like the floor of the NYSE; others nebulous, located somewhere in hyperspace, where buyers and sellers congregate, communicate and transact. Sometimes we personify the market, as a wily and implacable foe, as an irrational gentleman in a top hat, or as a mighty force of nature - cunning, baffling, powerful. A formidable adversary, to say the least.

In the interest of intellectual clarity and emotional control, investors will do well to discard the foregoing conceptions in favor of the blandly factual observation that the market is a place where they go to buy and sell financial instruments. One does not beat the market: it's about investment returns. Do your returns meet your objectives?

Investors in the aggregate are a mixed lot. Some individuals are well-informed and resourceful: to the extent they share their insights, they are worth listening to. Others are idiots, or manipulators and con artists of various persuasions. Tune them out. In any event, to label this group as "the market," and bow to their dictates, is unlikely to improve investment returns.

An Equity Portfolio

An investor or speculator who buys a stock is motivated by one of two ideas: 1) he expects the shares can be sold at a later date for more than he paid for them, or 2) he expects the company to a) make a profit and b) deploy the proceeds in the best interest of owners. The type 2 investor will buy shares at prices such that the proceeds meet his return criteria.

The first idea, at its heart, is about a greater fool. The investor becomes dependent on the whims and dictates of his fellows, the market if you will, who are unpredictable and unreliable.

With regard to the second idea, simply reporting a profit is not enough. The investor should ascertain whether management has the skills and motivations to reward shareholders by creating and returning value. Additionally, the shares must be purchased at prices that are consistent with return criteria.

A review of dividend practices, mergers and acquisitions, borrowing, capex, buybacks and compensation, together with published remarks on capital deployment, will generally suffice.

The investor's approach and motivations will affect his attitude toward hedging.

Hedging

I was out riding with a friend the other day, and was somewhat surprised to note that he habitually stopped at green lights. After several instances, I questioned him. His answer: "My brother is crazy, he always runs red lights, so I stop in case he's coming."

An analogous line of reasoning might be applied to hedging. The sane and rational investor, with a portfolio of profitable and capably managed companies, may wish to guard against the conduct of his fellows, who could panic at any time and drive the market down. I'm not sure how well the metaphor (or simile) actually works in practice.

Here's the point: An investor who is motivated by the idea of finding a greater fool is at the mercy of "the market." Hedging is one more way of second-guessing his adversary, and it may prove to be expensive and/or counterproductive.

On the other hand, an investor who has paid fair prices for stock in companies where he has a reasonable expectation that they will be profitable and deploy the proceeds for his benefit is only concerned with liquidity. If he needs funds for personal use, he doesn't want to be in the position of selling his stock for less than its intrinsic value.

Investment Implications

Hedging is not a one size fits all strategy. Although I enjoy the occasional speculation, I'm primarily a long term investor as described above. I maintain cash reserves sufficient to meet my anticipated draw for one year, as well as a separate emergency fund for unforeseen occurrences.

After putting all of this through the blender, with SPY just below $142, I made the following trade:

Buy to open SPY January 2014 160 puts.

If SPY continues to advance, which I consider the most likely outcome, I plan to add to the position at $1 increments. I've done this in the past, and it's been profitable. With patience, substantial hedges can be accumulated at a reasonable entry point. The in the money puts behave very predictably, and can be cashed in as needed in the event the market declines.

Rehashing past experience

My first effort at hedging, pre-crisis, involved buying long-term out of the money puts on the S&P 100 index ($OEX.X), about 10% below the market, and rolling the resulting positions forward and upward as the market advanced. OEX at the time had very low implied volatility, and included a lot of financials. This went on for a year or more. The hedge performed extremely well in the financial crisis. Regrettably, I closed it way early. This approach is too expensive under today's market conditions.

Subsequent efforts, undertaken on an ad hoc basis, have consisted of in the money puts on SPY, distant expiration, as well as out of the money puts on XLF, about 15% below the market. Both were successful, in that the puts were sold at a profit when the market declined.

As a cautionary tale, in March and April 2011, I elected to hedge heavily, at the same time chasing the market higher, using options for both sides of the trade. Kind of like driving with one foot on the brake and one on the gas, in retrospect. I wrote an article describing the strategy, at some length. I had mild reservations:

While some of the foregoing may seem complex and counter-intuitive, if a few principles are applied consistently in developing solutions to problems as they occur, improved results will follow.

The situation progressed in an orderly manner through late July, as I liquidated the hedges and reinvested with an eye on the inevitable recovery. In early August, the bottom fell out, my handpicked high beta positions headed south, and the hedges had been sold. Not pretty. Losses were realized before the more or less fortuitous recovery occurred.

My experience, as I interpret it, suggests that hedging should be simple and opportunistic. With the market at 52 week highs, and approaching a midpoint value by my methods, a patient investor can look to profit from a correction, while going about his business.

Source: Hedging: The Relationship Between 'The Market' And A Portfolio