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David Pinsen
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I founded Launching Innovation, LLC, to bring together developers, designers, and academic finance experts to create easy-to-use tools to solve complex problems for investors.
My company:
Portfolio Armor
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Steam Catapult
  • Crash-Proofing Your Portfolio While Continuing To Ride The Bull Market 3 comments
    Nov 29, 2013 10:35 PM | about stocks: QQQ, GLD

    Another Ominous Chart

    On Twitter recently, macro trader "Dividend Master" shared this ominous chart of NYSE margin debt, noting that previous spikes coincided with the end of last secular bull market, in March, 2000, and preceded the end of the previous cyclical bull market by a few months in 2007.

    Dividend Master isn't the only market participant to share a scary chart recently -- fund manager John Hussman tweeted another recently, suggesting the market was in the late stages of a Sornette Bubble. One of these crash predictions is bound to be right eventually. But there's an opportunity cost to having a constant bunker mentality: if you put most of your money in cash, you'll miss out on any further upside; if you pour money into an inverse ETF, you'll rack up losses while you wait. Here is a way to hedge against a significant market correction which won't put a lot of drag on your returns if that correction doesn't happen over the next several months.

    Hedging With Optimal Puts

    0.80% cost, uncapped upside.

    These were the optimal puts*, as of Friday's close, to hedge 1000 shares of the Nasdaq 100 tracking ETF (NASDAQ:QQQ) against a greater-than-20% drop over the next several months.

    As you can see at the bottom of the screen capture below, the cost of this protection, as a percentage of position value, was 0.80%. Note that, to be conservative, the cost was calculated using the ask price of the optimal puts. In practice, an investor can often buy puts for less (i.e., some price between the bid and the ask).

    With this hedge, you'll limit your downside if a major correction occurs over the next several months. And if the market keeps roaring higher, assuming you're otherwise fully invested, so will your portfolio minus the 0.8% or less you allocated to this hedge.

    Possibly More Protection Than Promised

    In some cases, hedges such as the one above can provide more protection than promised. For an example of that, see this post about hedging shares of the SPDR Gold Trust ETF (NYSEARCA:GLD).

    *Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance PhD to sort through and analyze the available puts for your stocks and ETFs, scanning for the optimal ones.

    Stocks: QQQ, GLD
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Comments (3)
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  • SeekingTruth
    , contributor
    Comments (1349) | Send Message
     
    Thanks for your interesting idea. It's the kind of information and suggestions that I like to explore and consider right now.
    The main problem that I have with it is that it places all the marbles on one put, and one with a 20% drop at that.
    This is not the kind of protection that I am comfortable with, although if one nails it, fine , all is well.
    There are a lot of dip and bounce scenarios, drift down, etc. that are far less than 20% that are possible in the next 6 months although I do include a 20 per center (or more) as quite possible also.

     

    I would prefer to buy three puts at say, approx. 6% drop, 9% drop, and 15% drop, just as a mere suggestion.

     

    This would have put you in the money on all the last three dips for example, but I don't suggest this without further analysis , but only as a general idea as certainly things won't repeat the same of course.
    Reports today that the big money is finally starting to get as nervous as I am. "If" true, the scenarios are very broad, i.e. from a slow drift down, where you probably lose on a 20% put, to sharp spikes down of 6 to "X" %.
    This is why I would like to have the 6 to 15% area covered also, once I decide to buy puts. preferably at the end of an exhaustion rally at a higher level , but , of course, things are seldom so convenient.
    Your response or any comments highly welcomed.
    2 Dec 2013, 03:20 PM Reply Like
  • David Pinsen
    , contributor
    Comments (1076) | Send Message
     
    Author’s reply » Thanks for the comment. Regarding your questions, a couple of points. The first is that, as I noted at the bottom of the post, sometimes hedges against a greater-than-20% decline can end up offering more protection than that. The second is that you can hedge against smaller declines if you like, there's just a tradeoff of cost to consider.

     

    For example, the cost of hedging against a >15% decline in QQQ over the same time frame using optimal puts, as of today's close, was, 1.35% of position value. The cost of hedging against a >6% decline in the same manner was 4.85%. Now, if you are willing to cap your potential upside, you can lower that cost by using an optimal collar. Checking now, the cost of hedging against a >6% drop over the next several months, while capping your upside at 6%, is 1.82% of position value.

     

    You can try various approaches with Portfolio Armor, but the examples above ought to give you some idea of current costs and tradeoffs.
    2 Dec 2013, 04:59 PM Reply Like
  • SeekingTruth
    , contributor
    Comments (1349) | Send Message
     
    David,
    Many thanks for the reply.
    The many combinations are intriguing, and somewhere in there some put sells can also lower the cost after the market has dropped enough to meet one's own criteria and triggers.
    I would not purchase 6% puts unless I thought that the market had peaked for the time period chosen and due for at least that much pullback.
    I do not think we are quite there yet, so the 15% would make more sense to me now as serious and/or catastrophic loss protection.

     

    Tax loss selling etc., could easily prove me WRONG about the 6%, but tax loss selling does not "usually" drive December into negative performance (although in many other ways we are due) - we'll see.
    Thank you for the conversation, it has been worth it.
    I look forward to your future posts.
    2 Dec 2013, 07:30 PM Reply Like
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