First off, let me just say that at the moment the stock market looks great.  Every time you think it might buckle, it simply pauses and then powers ahead.  As a dyed in the wool “the trend is your friend” kind of guy I am hesitant to stand in the way of progress.  And despite the ever present temptation, I still hesitate to attempt to “pick tops and bottoms with uncanny accuracy” (mostly because I can’t). 

Nevertheless, as a student of the market I am reminded that there is a certain “ebb and flow” to things as far as the major stock market averages are concerned.  And one of the “tricks of the trade” (so to speak) that I learned from Optionetics instructors, the late George Fontanills and also from Gustavo Guzman, is the idea of using a small portion of capital to hedge against something very bad happening if the market suddenly decides to go the other way.  Or to put it another way:

Jay’s Trading Maxim #206: When you find yourself becoming quite pleased and comfortable with the way things are flowing, beware the ebb.

This may be a good time to consider this idea.  Just to be clear, please notice that I did not just “call the top” and suggest that you “sell everything”.  The recent rally in the stock market has displayed a lot of “thrust”.  Such moves have a tendency to extend themselves, so a bearish hedge might end up looking like a bad idea in retrospect if the up move continues.  Still, there are a few potential “clouds on the horizon”.  And the ideal time to hedge is before the storm.

To use a seasonal analogy, if a hurricane is moving in your general direction and may or may not make a direct hit on your location, the time to board up the windows is before the storm hits, not as it is making landfall right outside your front door. The same is true in the financial markets.

A Few Clouds on the Stock Market Horizon?   

I wrote a few weeks ago about the history of September in the stock market.  One of the charts I included is repeated in Figure 1.  It displays the growth of $1,000 invested in the Dow Industrials:

-Only during trading days 1-14 during the month of September since 1955 (blue line).

-Only during trading days 15-21 during the month of September since 1955 (red line).

Figure 1 – Growth of $1,000 during September trading days #1-14 (blue) versus September trading days #15-21 (red) since 1955

As you can see in Figure 1, there has been a strong historical tendency for weakness in the stock market during the latter part of September.

Also, a few notes on Figure 2 below:

Figure 2 – SPY possibly setting up for at least a pullback

-The Elliott Wave count on the daily SPY chart is suggesting at least a short-term pullback into early October.

-The ProfitSource Range Projection tool is suggesting the possibility of decline to the 135-136 level between late September and late October.

-Lastly, both the MACD indicator and the MACD histogram are presently displaying a bearish divergence with price – i.e., price has made a new high while both of these indicators are lagging.

None of this means that the stock market is definitely headed lower in the weeks ahead.  Still, it is enough to suggest that now is the time to consider a low cost hedge position.

Hedging with SPY Options   

One of the best ways to hedge against an overall market decline is through the use of heavily traded options on ticker SPY, the exchange-traded fund that tracks the S&P 500.  The possibilities are limitless.  Figures 3 and 4 display a position that almost certainly fits under the category of “positions you’ve never considered before.” 

Figure 3 – A put butterfly using SPY options

Figure 4 – Risk curves for a put butterfly using SPY options

This odd looking position involves buying three different put options and selling one other.  In a nutshell:

-We are buying two November 142 puts to gives us immediate profit potential if SPY starts to fall.

-We are selling three November 130 puts to pay for about 40% of the cost of the November 142 puts.

-We are also buying one November 128 put and one November 118 put in order to give this position explosive potential if the stock market were to go completely to heck between now and November expiration.  The total cost of these two options (the 128 and the 118) is $83, which basically amounts to a cheap insurance policy if something catastrophic happens in the stock market in the next two months.

Note once again that we are not “predicting” that the market will decline, we are merely spending a relatively few dollars to enter a position that can offset some of our downside risk if the market does in fact decline.

Going back to the Range Projection tool in Figure 2, if SPY did in fact fall to 135.60 by October15th, this position would show an open profit of roughly $740, or about 164% of the cost of this position.        

For an investor actually considering a hedge position such as this one, it is also important to consider what you will do if the stock market continues to move higher.   Ideally you want to leave a hedge position in place as long as possible “just in case.”  But if you are thinking that you might exit the hedge position early – or perhaps exit one position and roll into something else, it is always better to “plan ahead” regarding what might cause you to act and when, rather than waiting around to “see how it goes” and assuming that you will “know what to do when the time is right.”

Summary

Hedging is something that most investors never consider. While many professional investors hedge on a regular basis, most individual investors tend to view hedging as sort of a “lose-lose” proposition.  If they enter a hedge and it turns out to be unneeded they kick themselves for “wasting” the money they spent to enter the hedge in the first place.  And if the market does decline and the hedge makes money, they tend to kick themselves for not doing even more to protect themselves from downside risk.  

So regarding the question of whether to hedge or not to hedge, let’s to go back to my earlier analogy. 

The question basically is “is it better to spend the time boarding up the windows and hoping you are wasting your time, or to not board up the windows and wishing that you had?”

Jay Kaeppel

Staff Writer and Trading Strategist

Optionetics.com ~ Your Options Education Site