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Time for a Correction? 5 Hedging Strategies

Jan. 19, 2011 9:49 PM ETSPY, DIA, QQQ, XLE, XLV, FCX, MON-OLD, XLB
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As the market has been grinding higher over the past few months, we've heard many bears state that we are overbought and that we're due for a correction. The overbought part was likely true, but no correction was in sight on the back of QE2. I don't like being short when the printing presses are on full steam and I believe a real recovery is underway, but I'll never flinch at taking a profit or even use some of them to put on some hedges... After all, would you buy a house without insurance?

I have spent the majority of Wednesday evening reviewing charts - mainly of indices and sectors, to see where I would like to place my hedges. When I believe we are due for a correction, and only expecting a minor 5-7% one if that, I have no problem putting up to 2%-3% of my entire portfolio value into hedges. Just like it is smart to be diversified when purchasing equities and call options, it is smart to be diversified when shorting and buying put options. In this article I will show you 5 ideas on how I plan on hedging my portfolio and why I believe it is a good idea.

Idea #1: Hedging the S&P 500
Most portfolios have exposure to the S&P 500, so it is worth spending some money on insurance against this index.
(click chart to enlarge)

As we can see from the S&P Index SPDR (SPY) chart above, we had a pretty ugly day on heavier than normal volume Wednesday. You can also see that the RSI or relative strength has been trading in overbought territory since January 3. Typically it is a good time to lighten up or purchase protection when trading in overbought levels like this. We sold off by close to 1% Wednesday and the RSI still is trading at the higher end of the range, 64.59. You can pull up a chart of the VIX or Volatility Index, which trades inversely to the S&P 500, and you will see the VIX was trading near oversold levels in that same time frame. The VIX also had a big 9% spike Wednesday regaining the 20 day moving average, the VIX is another great indicator to get an idea of when to hedge.

S&P Hedging Strategy:

Although volatility is cheap (yes even with the 9% spike Wednesday) I would purchase put spreads versus outright put options on the S&P 500 SPDR (SPY), but I would purchase more time versus if I were just buying puts I would likely choose to purchase less time. Purchasing more time requires me to be proactive as I might have to decide when to trade out of this strategy so the hedge actually works. I would purchase March 127 put options and sell (1 for 1) March 117 put options against them. This strategy would cost me roughly $210 per put spread and would protect me down to just above the 200 day moving average at 117. If the market corrects more significantly and the SPY is trading below 117 on March expiration this strategy would return $1,000 per put spread or a return of 476%. Of course us bulls out there don't want the maximum return from this spread, but it would certainly help pad the portfolio if the market did correct in such a manner.

Idea #2: Hedging the NASDAQ 100
Like the S&P 500, many of us have exposure to big tech names which fall into the NASDAQ 100. One way we can hedge many of our stocks in the NASDAQ is to purchase similar put spreads on the Powershares QQQ Trust (QQQQ).
(click chart to enlarge)

From the chart above, we can see many similar comparisons to that of the S&P SPDR chart. ETF was trading in overbought territory for days, heavier than normal volume to the downside. But the really bearish signal I see from Wednesday's price-action, and signals a potential key reversal, is that the QQQQ managed to open on the highs, which also happens to be higher than Tuesday's high as well as the 52 week high, but gave all of Tuesday's gains back closing below Tuesday's low and on heavier volume. This is called a bearish engulfing candle pattern and cannot be illustrated any better than this.

NASDAQ Hedging Strategy:

Again I would look at using the 20 and 200 day moving average to get an idea on where to purchase and sell put options. I would buy the March 55 put options and sell the March 50 put options. I could get this strategy for roughly $84 per put spread. If the NASDAQ corrected significantly and the QQQQ was below 50 on March options expiration this strategy would return $500 per spread or a return of 595%.

Next I will outline 3 specific sectors using the Sector SPDR ETFS. I have looked at many sectors and believe the three to follow have the greatest risk and could have the most significant correction if we get a pull back.

Idea #3: Hedging the Health Care Sector

This sector had some very ugly price action as well Wednesday. We can see a very similar bearish engulf candle pattern from the chart below of the Health Care Select Sector SPDR (XLV).
(click chart to enlarge)

We can see the ETF opened within pennies of its 52 week high before selling off throughout the day. This ETF also engulfed all of Tuesday's move on greater volume. Not looking too promising for the bulls out there.

Health Care Sector Hedging Strategy:

With this ETF I am going to stay shorter term and purchase at the money February 32 put options for $46 per contract. I am choosing to stay shorter term on this ETF because the volatility stands at a whopping 14.75% (sarcastic) for February, and because I am trading on this signal and because this is sector specific I wouldn't want to overpay for time value.

Idea #4 Hedging the Energy Sector

This sector is by far one of the best performing sectors since the most recent market bottom, which leads me to believe it may have the biggest correction if we get an overall market correction.
(click chart to enlarge)

As we can see from the Energy Select Sector ETF (XLE) above, it opened on the 52 week high and sunk like a stone all day engulfing Tuesday's entire move higher, all on greater volume. This again is very ugly price action and would signal me to sell energy stocks or purchase put protection. This is one of very few ETF's that traded above 70 on the RSI for more than 3 days.

Energy Sector Hedging Strategy:

I would also plan on purchasing shorter tem puts on this ETF, because this is sector specific and would think based on the ugly price action and recent overbought levels, it is due to correct sooner rather than later. I am structuring my bet on this ETF a bit differently than the last few. As you can see from the chart of the XLE above, the stock left a couple of gaps on the way up, and I believe those have a high probability of being filled if we get a pull back. I would purchase puts below the 20 day moving average at minor support near 68, and I would sell puts near 60. Therefore I would put on a February 68/60 put spread. This would cost me roughly $75 per spread. This strategy is a bit more bearish and factors in quite a significant correction, but selling the 60 puts versus the 61 or 62 puts didn't make too much of a difference compared to potential returns, especially because that lower gap which would need to be filled around 59.94. If this ETF sold off and closed at or below 60 on February options expiration this strategy would return $800 per spread or 1,067%.

Idea #5 Hedging the Materials Sector:

This sector was perhaps the ugliest of the day Wednesday. Many of the largest holdings in the Materials Select Sector ETF (XLB) such as Monsanto (MON) and Freeport-Mcmoran (FCX) have had unbelievable runs lately and need to take a breather.
(click chart to enlarge)

This ETF had an extremely ugly potential reversal day Wednesday . The ETF opened near the high and 52 week high and sold off the entire day on very large volume engulfing all of the previous two days moves higher. This stock also fell below the 20 day moving average for the first time since mid November. This again is a potential key reversal day to watch and would be a signal to sell material stocks or put on some hedges.

Material Sector Hedging Strategy:

As we can from the minor pull back in mid November the ETF broke below the 20 day but then bounced off of the 50 day moving average and continued a nice uptrend. You will also see Fibonacci retracement levels drawn on the chart which are also key levels to watch. The Fibonacci levels come in very close to the moving averages on the chart, but I will use both to structure my put spread. Again I would choose the February contracts to keep this hedge shorter term. I would purchase my first put near the 50 day moving average at 37 and sell put options near 34. If it broke below the 50% retracement, I would want to roll out into the next month and purchase another put spread (perhaps the 34/30) as the stock would likely head lower. This strategy would cost roughly $45 per spread and would return $300 per spread or 667% if this ETF closed at or below 34 per share on February options expiration.

The ideas outlined above are bearish strategies and should not be considered if you think the ETF will continue higher or have a very minor correction in the near future. However if you feel the ETF could correct in the near future, these strategies could help protect your portfolio. To get a better understanding of stock options and different option strategies please check out my Simplified Stock Option Trading E-Books. These are just examples and are not recommendations to buy or sell any security; if you're more bullish/bearish, you’ll want to adjust the strike price and expiration accordingly.

The reason option volumes have surged in the last five years is because they are a great way to hedge your portfolio as well as create income off of your shares (see chart here). Keep in mind when using this strategy it is essential that broker commissions are low enough to profit from the position.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in SPY, QQQQ, XLB, XLE, XLV over the next 72 hours.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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