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Hedging a portfolio in a bull market minimally dampens profits, but it can also make them elusive in those that are less strong. Identifying periods when hedging is optimal via an easily accessible, objective indicator may help the investor stick with a plan that stays the course when conditions are bullish and eases investor concerns when they are bearish. Traders can benefit by having an approach that addresses longer-term assets so that shorter-term term market assessments don't interfere with investment decision-making.

A technique I've used in the past with success is one of the most basic. It uses a 50-day simple moving average [SMA] and a 200-day SMA, assessed on a monthly basis. Rather than a crossover approach, the system looks only at the relative position of the SMAs. When the 50-day SMA is above the 200-day SMA, conditions are bullish and when the 50-day SMA is below the 200-day SMA they are bearish.

An end of the month assessment is used in place of an SMA crossover to minimize the impact from whipsaws-moves in the 50-day SMA around the 200-day SMA as it approaches the longer-term average from above or below. In the past I've used the S&P 500 Index (SPX) as the benchmark index to determine whether a portion of my assets should be invested in equities or cash. This article explores using the approach as a timing tool for hedging decisions. It also checks a shorter-term pair of SMAs (20-day and 50-day SMAs) to see if this improves the signal.

Approach Summary

Initial Investment: $10,000

Security: SPY, Standard & Poor's [S&P] Depository Receipts for the S&P 500® Index. This exchange-traded fund [ETF] has a strong positive correlation with SPX and can be used as proxy for the US equities benchmark.

Signal: Hedge the position using an initial delta neutral approach when the 50-day SMA is below the 200-day SMA on expiration Friday. Maintain a position that is not hedged when the 50-day SMA is above the 200-day SMA on expiration Friday.

An initial delta neutral hedge is created by purchasing next month, at-the-money [ATM] puts on the following trading day, usually a Monday. Prices use end of day values for the puts and the position is re-assessed at the next expiration. As a result, the position is not maintained as delta neutral throughout the month. A new position is established at the next expiration, if conditions warrant.

The monthly, two SMA approach delays entries and exits; however, it hedges the investment during bearish periods using an objective approach. It also minimizes commissions and slippage. Fortunately the last couple of decades have provided a variety of markets to test different conditions. Worden Brothers data is used for SPY closing data and Platinum is used for options data. Unfortunately I don't have quick access to option data from 1989, so two different periods are tested, using two different approaches as follows:

• The first test uses a twenty year period from Jan 1989 through Dec 2008 and is invested in SPY when the signal is bullish on expiration and is invested in t-bills when the signal is bearish.
• The second period tested is the three year period from Dec 2004 through Dec 2008 and maintains a constant position in SPY. A hedge is put in place when the signal is bearish and no hedge is used when the signal is bullish.

Results for the two approaches will be compared using the common three year period. Equity commissions included in the results are $10 each way, while option commissions include a base of $8 plus $1 per contract.

Results for Equities Only

Table 1 provides return results for the 240 month period from 12/16/1988 through 1/16/2009. The first column provides SPY assuming an investment the entire period, while columns 2 & 3 use the SMA market timing technique. When the SMA signaled an exit for SPY, the Three Month Treasury Constant Maturity Rate from the St. Louis Federal Reserve Bank's Economic Data [FRED] was used. Note a simple rate was applied to the monthly period for the Treasury rather than the appropriate compounded rate of return.

Table 1: Market Timing Results for SPY

Although the shorter period SMAs (20-50) had similar end of period returns, the variation for returns on a monthly basis was about half as volatile (56% = 2.6/4.6), even when commissions were considered. So a quick look at the results suggests the short-term timing system returns are superior to a fully invested approach.

The longer term SMAs similarly reduced portfolio volatility while also improving both end of period and annualized returns. Given this first look, there seems to be a good argument for implementing a timing system on the core portfolio holdings. The results will be further explored and discussed in next Thursday's Platinum Toolbox article (12/3/09). This article will also include results for a timed option hedge.

Portfolio Charts for Hedged Portfolios Dated 11-3-09

Figures 1 through 4 provide an update for the portfolios discussed in November's Platinum Toolbox article. Each portfolio is identified in Figure 1, and portfolio performance for the period provided in Figures 2 through 4 using Platinum Pro's Portfolio Charts. Please see November's Platinum Toolbox for information on how the portfolios were constructed.

Figure 1: Hedged Portfolios Created 11/3/2009

Figure 2: Portfolio Chart for Portfolio 1

Figure 3: Portfolio Chart for Portfolio 2

Figure 4: Portfolio Chart for Portfolio 3

These results will also be assessed in future articles.

Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site

Questions for Clare? Please visit the discussion board on the homepage of Optionetics.com.

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