Seeking Alpha

Do You Have Protection? Conserve Your Gains, Trim, Hedge, And Make Some Downside Bets

by: David H. Lerner

I created this content irrespective of where the market might go today. In fact, the futures were up nicely while I was writing this.

The time to take profits is when the market is going up. The key to trading success in my opinion is having an unemotional approach to taking profits.

Trim, hedge and think about downside bets. Your goal is to rebuild your cash to 25% to 35%.

There has been no relief from volatility; we could sell off hard and still go to new highs in the next few weeks.

I wrote this before the unemployment news, so this is not about jumping on any sell-off before the market open

Right now, the futures are up decently, and based on yesterday's positive ADP employment numbers, my assumption is that the government numbers will confirm positive employment results. So why am I talking about getting defensive? Partly because I have a discipline of cash management, and partly because even though I called this rally, I am not married to it. I want to be as cold-blooded as possible. The stock market is not my football team, and it shouldn't be yours. Yes, I really do want to see new highs, and no I don't want to see interest rates fall back. I have expended a lot of emotional energy getting behind this rally, but success is defined by generating alpha and holding on to it. So I know the trolls will be out in force saying, "Hey, you said we are going to new highs and now you are talking about selling?? Make up your damn mind!"

First, that is not what I am saying. I do believe we are going to new highs, but I never said we are taking a moonshot straight up to breaking all-time highs. Secondly, managing your trading based on growing your cash segment, and then spending it down on opportunities is the way I recommend running your trading/speculation portfolio. My SOP is to start recommending generating cash as we move up, with the assumption that you will bank some of your gains. By trying to do this mechanically, you eliminate the emotion involved with taking profits. Many new traders will, once they decide to take profits, want to take ALL the profits. Then when the stock continues to go up, will have "seller's remorse". Perhaps the next stock that has good gains will just sit in the portfolio, and give up those gains when the market sells off. Also generating cash is the easiest and the most effective hedge there is.

Admit it, you are All In

So, I assume that anyone reading this right now is All In. In other words, you don't have a nickel in cash right now. Let's engage some common sense; the best time to take profits is when your portfolio is going up, not when the market is going against you and EVERYONE is selling. What I want you to do is trim each winning position you have. Take off 3% to 5% of each position. If you have any new position that is up more than 20%, consider taking profits by selling enough equity to capture that profit, and keep the rest. Fight the desire to take all the profit, or to let your entire portfolio ride. The first time you do it might be hard, but what discipline isn't? Just try to remember the last time the market took a nosedive and you had no cash to take advantage. You were also a sitting duck watching your portfolio value tick down day-by-day. Not a good feeling, right? So let's make some hay while the sun is shining. Your goal is to build towards 25% to 35% cash. DO NOT DO THIS ALL AT ONCE! Slowly trim 3% to 5% of your portfolio over time, little by little every trading day. At some point, you will need to trim your losers too, but let's start with the winners for now.


Hedging is taking positions that will pay off if the market goes in a different direction than your overall strategy is betting for. So my overall direction is up. Generally, I am a bull. Statistically, the market goes up more often than it goes down. However, when it does go down, it tends to go down more sharply than it goes up. The old saw "the market goes up in an escalator and goes down in an elevator" is very true. Also, you need to look at hedging like paying for insurance. You should never spend more on insurance than what your potential losses might be. In fact, insurance should be a tiny expenditure or it doesn't make sense. Also, you really don't want the hedge to work. I want the stock market to continue going up, not down. So there is a good chance that your hedge goes to zero. You aren't upset with paying for health insurance and not needing to go to the hospital to get your money's worth. Well, health insurance is too expensive, but that is not the topic here. Okay, so I will list some hedging ideas, but please start small. Don't put on all these hedges today. Do your own research and get comfortable with the concept. I will express these hedges in options trades. With options, if done right, your risk is predefined, and using the insurance analogy, you are leveraging the amount of your investment so that the pay-off will be meaningful if the market goes against your bullish assumptions.

VIX: The VIX spiked to 21 and has retreated strongly over this week. If you see the VIX back under 14ish, consider executing a Call-Spread with the long contract in the money and the short call @ 20. Start with one contract. Look at the overall cost; does the idea of losing the premium you are paying for insurance make you uncomfortable? Then don't do it. I would recommend take the protection out to an October expiration

SPY and QQQ: The VIX is a measure of the "Implied Volatility" of the S&P 500, so as the VIX falls, SPY (the S&P 500 ETF) options premium naturally falls. So in this case, AGAINST our assumption of the market going up, we want to create a "Put Spread", which means buying a Put in the money (where SPY is trading at) and then selling a lower-priced put, "Sell Open". Let's wait for the VIX to fall before we put this trade on. Again, your brokerages have webinars on creating Call and Put Spreads. The thing about selling a Put is that you will take delivery of that SPY ETF if the market falls through the strike price. Study over the weekend and then execute. If the idea that you might end up with the S&P 500 ETF makes you uncomfortable then a Put spread is not for you. However, I bet most of you already have S&P 500 ETFs, and in order for SPY to get delivered to you, it means that you made bank on the LONG Put. You also were paid for the privilege of selling that Put. Do the same with QQQ; this is the Nasdaq 100. Most of our names are in QQQ and they will move more sharply with any sell-off.

The precious metals have been retreating a bit against this furious rally. I asked you to close out your hedges last week and use the funds to go long. Now you should start putting some funds back into GDX, GDXJ, GLD, and SLV with the thought that if we do have some consolidation of the indexes. Look to go long in the money, and spread with a short call at a strike price that gives you some good gains. Again study up on Options and get comfortable before you decide to go in. Also, don't over-hedge. This rally can continue going up like a rocket ship.

TLT: This is the ETF that shows the value of the long bond complex. Meaning that as interest rates fall, TLT goes up. It has fallen hard the last few days, but if the market falls, I suspect a rush back into the long bond reflexively. In this case, I want you to think about a Call Spread. Calls will capture the drop in interest rates.

130K on employment was a bit shy; the market is happy with that

The market is comfortable with the unemployment number which came in a bit shy. The market is taking this as good news confirming that the Fed will cut at its next meeting on September 17-18. Again this is not about the current situation; the market will probably go towards new highs. However, just look at the chart, the last month looks like a coxcomb with rapid ups and downs. I think we continue this choppiness at this elevated level (2,900-3,000). That is what I am trying to help you with. I want you to capture what might be fleeting alpha, by mitigating risk.

Okay now for two downside bets

The first is keying off of D.A. Davidson's downgrade of Beyond Meat (BYND) with a target of $130. It is working on what it thinks is an overly optimistic Total Addressable Market (TAM). I respect D.A. Davidson's number-crunching abilities, so let's go with that. Loyal readers will recall that I strongly disdain the stock. Mostly, by the way, because the founders treated the shareholders poorly. Also at this point, there are numerous competitors coming on the market, and that will also devalue BYND's prospects. So let's take a Put spread on BYND with an October expiry. I would take a long call slightly out of the money; let's say 155 and spread it at that $130 PT for the strike. That means that if BYND goes below $130, you will get its shares. That said, you could close out the short call and still have plenty of profit if the trade goes the right way.

My thought is if we do get some selling pressure, BYND will fall harder than the market. I think that 130 could hold since that is where D.A. Davidson has the price target at. If you are a trader, you can go long in a name that you think has more downside, but could bounce temporarily, so what I am saying should not sound strange to fast money traders. That said, if the idea of betting against a company makes you uncomfortable, don't do this. There are plenty of good long ideas out there. I haven't priced this or any of the other "short" ideas out, so this is an idea to provoke thought. To introduce options as an investment vehicle. You should not be using Margin to trade or Shorting at stock. This is a great way to lose big money. Options used in the right way allows you to use leverage, but limit your risk.

Align Corp. (ALGN) - I am introducing the idea of a "pairs trade" as a concept. SmileDirectClub (SDC) is going public. It is going up against ALGN. SDC caters to the mass market with clear aligners for people who have teeth slightly out of alignment. Most of its customers were patients of orthodontists as kids, and now their teeth went crooked again. ALGN works with orthodontists and is more or less ceding this "consumer" segment to SDC. I think stock participants will not make this distinction and assume that SDC will their steal share too. So I would recommend executing a Put spread against ALGN. In a traditional "Pairs Trade," you short one stock while going long with the other stock. SDC is not public yet, and we don't know how much value will be assigned to it. So instead this is an "imaginary" Pairs Trade. I think the IPO of SDC will knock the stuffing out of ALGN. So bet against ALGN and leave SDC alone for now.

One last word about Options. If the premium you paid for a long Call falls by 50%, close it out. Studies have shown that once an option loses its premium by 50%, chances are the option is not going to work. That doesn't mean you don't put on a new trade if you have the conviction; that is up to your judgment. 50% down should be your "Stop".

Okta Inc. (OKTA) and CrowdStrike (CRWD)

I want to end with a recommendation to the long side, since I am bullish at heart. Both of these names have been weak lately, and I think you should buy them on your buy list. If they remain comparatively under-priced and you have built up you cash, I think you should accumulate these two names.

Have a great weekend!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.