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Is a market correction on the horizon?

Jan. 25, 2011 1:12 PM ETVXX, VXZ
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Portfolio Strategy, Long/Short Equity, Special Situations

Seeking Alpha Analyst Since 2008

Dr. Kris has two degrees from MIT because one just wasn't enough. Her life goal was to figure out the universe and having done that (at least to her satisfaction), she decided to tackle something even more difficult—the stock market. Applying the scientific method along with an insatiably curious mind, she began trading stocks, futures, and options in order to find the holy grail to market success. She's discovered to her immense satisfaction that not only is there one way to succeed but many. Combining her love of cooking with the stock market, she's devised recipes for investment success designed to please the palate of most investors. Dr. Kris currently manages a private equity long/short portfolio and writes of her current research projects that appear on her website, StockMarketCookBook.com. Her most exciting project is applying market timing models to Modern Portfolio Theory to not only give greater returns but at substantially lower levels of risk. (See PortfolioPreserver.com for further information.)

Ben & Company is back in the boardroom to determine if they should start to worry about inflation. The Street seems pretty confident the Fed will leave interest rates alone but you can be sure that the decision notes will be examined with a fine-toothed comb

We can't do anything about the Fed but we can do something to protect our portfolios. Any hint of negative wording could provide the catalyst for a market correction. From a technical standpoint, we're do for one any day now, anyway.

Why? Because the daily chart of the S&P 500 (SPX) has been trading above its 40 day simple moving average (dma for short) for almost two months now. That's getting to be a long time. I did a cursory check of the chart from 2000 to present and found that out of the 33 times the SPX has traded to the upside for periods lasting a month or more, the index returned to its 40dma seventeen (17) times after a month, nine times (9) between one and two months, four (4) times after three months, and just one time for a period longer than three months which was a record five months hit in 2006.

Currently, the SPX has been trading above its 40dma for almost two months. Sure, we could go on like this for another month or possibly longer, but the odds are sharply against it. So, what's an investor to do? Well, you could protect your long position with puts on the SPY (the S&P500 tracking stock), or you could play the volatility (which is negatively correlated to the broad market) by buying a call on the VXX, the short-term volatility ETN, or the VXZ, the medium-term volatility ETN. If you'll be hedging for more than a week, I'd recommend the VXZ to avoid the contango problem and use March options.





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