November 22nd, 2009

Protect Yourself Against An Imminent Market Correction

Winning in this game we love means your portfolio out performs a benchmark index because if all you do is match the market, you might as well put your money in an index fund or market index ETF and not even go through the motions of playing. However, if you do play then beating the market when it trends up is tough and demands near perfect stock selection (pick stocks with positive relative market performance and cut losses from mistakes early). But beating the market when it trends down is easy …. if you successfully manage or avoid the downturns.

The important questions isn’t if it’s true to the Lunar cycle theory or not (last week, the market has sold off 1.6% since the New Moon and there are still seven more trading days until Full Moon on Wednesday, December 2) but where the market will be in 3-6 months and how best (i.e., with the least risk) might we prepare our portfolios to make the best advantage of whatever move occurs.

Optimistically, momentum indicators have finally confirmed that a bull market is intact since the 200-dma just recently crossed above the 300-dma. This long-awaited cross puts all the moving averages in perfect alignment, fastest on top to slowest, with the Index above them all, an arrangement I’ve dubbed a “bullish cross”. In March 2008, the mirror image of this alignment (slowest on top to fastest with the Index beneath all) confirmed the onset of a bear market of major proportions, the Financial Crises Crash. A final step to nailing down the bull market will be when the 300-dma finally turns up for the first time since January 8, 2008. Mathematical extrapolations (see my post “Mark These Dates“) say the turn should occur around December 3 (just in time, coincidentally, with the new lunar phase).

Many traders and investors believe this bull market has unstoppable momentum and has now finally gained a permanence, overwhelmed the bears and will continue for the foreseeable future. But others who look at fundamental economic and financial indicators like P/E ratios or Fibonacci guidelines (50% retracement of bear market decline) argue the market is due for a correction.

I’m in the latter camp, albeit having arrived early (see “Begin Pruning, Trimming and Weeding Your Portfolio” of October 16, “Ascending Everest: the Mid-Station Rest Camp” of October 18, “More Evidence We’re Approaching a Top” of October 23 and “One View of Market’s Future” of November 9). I prefer both the simplest of momentum indicators (moving averages) and the simplest of trend analysis (resistance and support trendlines). They’ve suggested to me from the outset of this bull move in March that the 1125-1150 area could be significant because it is an area of past congestion and an area where equilibriums between buyers and sellers have ended in reversals (in other words, an area of many pivot points). There’s a strong likelihood, therefore, that the area can again produce a pivot point (why? because of market psychology and behavioral finance).

“If so, what’s our strategy”, you must be asking? How can we create some protection with minimal risk while at the same time leave room for upside opportunity in the event that our calculations are wrong? We know that the long-term momentum indicators point to further upside gains; it’s the 10-15% market correction we want to protect against. It’s at this point that the bald former football player on Fast Money shouts, “I hedge my bets through options!” Of course, he’s “selling his book”, as they say on The Street. However, this time he may just be right. What options do we have?

  • “Buy and hold”: only protects against opportunity losses in the event we’re wrong and the market continues going up; but it provides no protection against real losses if the market goes down instead.
  • Diversification: only a partial successes – if you select correct places to diversify into and if all asset classes don’t move in tandem as they did last year.
  • Sell positions and move into cash: outstanding strategy in confirmed bear markets but a less than optimal defense in corrections because it protects against losses but creates opportunity losses if our timing is off either in getting out or in coming back in.
  • Hedge positions: Bingo! Involves limited risk yet offers upside potential

Assume that you have a $100,000 portfolio whose performance moves precisely in tandem with the S&P 500 Index. A simple and direct option hedging strategy is available: buy SPY puts. For about 9.5-10.00% of the value of the portfolio, or approximately $10,000, you could buy ten on-the-money puts with March expiration that would insulate a $100,000 portfolio through increased option value (beyond the cost of the premium). If you were wrong and the market moved up, at expiration you would retain the increase in portfolio value offset by the premium paid for the options.

But the “insurance” premium of the options and exposure to risk can now be reduced without giving up any upside potential because of the introduction of Ultra (2X) and UltraPro (3X) SPY longs and shorts. These ETFs also have call and put options available; because these ETFs themselves are leverage, ProShares now provides the means for a more efficienct leveraged investment “insurance”. This ability of buying options on double and triple ETFs appearsto be an inequality in the market that doesn’t appear to me to have yet been arbitraged away. Rather than costing 9.5-10.0% through options on the underlying security, and equal portfolio value can be “insured” with fewer on the money calls or puts on SPY UltraShort (SDS) or UltraLong (SSO) ETF’s, respectively, for about 4.5%, half the cost. [Because they are only less than 6 months old, I have excluded the UltraPro etf’s from consideration.]

Click here to download a spreadsheet summary of this SDS calls hedge strategy (with comparison to SPY puts), plus this graph:

Note that the spreadsheet is an example using data as last week when I purchased these options. Before you pursue the strategy, you should do your own analysis and evaluation for correctness and appropriateness for your own situation. I welcome comments and suggestions on why my analysis might be faulty or how it might be improved.

Subscribe below or click here to learn more about help for navigating turbulent markets.
  • Anonymous

    S&P gains 0.8% average around Thanksgiving(49/59 of the last years were +)Any hope this year?

  • Gary

    I've always questioned why small retail traders would ever waste their time and capital on hedging strategies. None of us are big enough to move the market.

    If you hedge and the market doesn't drop you just threw away capital.

    If it does drop you now have to time the move perfectly to get out of your hedges. If you don't and the market pops back up before you exit your hedges you again threw away money.

    For the retail investor it's much easier and more cost effective to just adjust position size as a means to hedge.

    If you think the market is going to drop then tighten stops on a portion of your portfolio. That way you will only ride down what you are willing to hold through the correction.

  • Anonymous

    GURU,how much do you rate the Nikkei Index and the ISM Index as accurate leading stock market indicators in your work ?Also would you agree that the US stock market is trading at a level showing a 5% real growth in GDP for 2010?Thanks for any info.

  • Anonymous

    Joseph Meth,

    I am really interested to read your older posts but I can find them.

    I'll be happy if you can support a link to the previous ones.

    Thank you!

  • Joseph Meth

    All my previous blogs are available from the white Archives box in the right-hand panel just under the Facebook box. You can either do a Google search for specific phrases (make sure you click the blog button) or scroll back to prior months. Hope you enjoy the reading.

  • Joseph Meth

    I, like you, have seldom hedged and instead have moved to cash when I'm certain the market is going into a sustained decline. This may be a special situation since the correction we see coming is arriving in such an early stage of the bull market's life cycle that it may not be necessary to sell out of positions.

    If the correction lasts longer and is deeper than now expected then moving into cash is what I will do and will recommend. I just don't think we're there now or that it is necessary yet.

  • Joseph Meth

    I haven't looked at the Nikkei or any other external index for that matter as a leading indicator but it's an interesting thought and one worthy of more research.

  • Anonymous

    Is there a good ISM index chart from bloomber? thx!

  • Minnesotalee

    If you hedge, hedge to the upside. That's what the BEARS are doing. In otherwords whether you are a BEAR or a BULL buy calls and sell puts, or hedging against the BEARS' wishes, I would continue to buy all the way up to 1295. This market will not turn or stagnate around the 1125-1150 area because there's no tech support for that. All the PO's indicate beyond this. Now we may get a pullback but not the 10% variety, because there is too much $$$ waiting to get in before year's end. I am pushing for higher numbers in support of the technicals because, oops, the sequential fundamentals in every indicator out there will be better than its comparison. Like in poker, I am all in. No cash left for a future game. Finally the $US is going down.

  • Joseph Meth

    You might want to check out the charts at I'm not sure where you might be able to find the historical time series though.

  • Pingback: This Damaged Market Is Ready for the ICU | Stock Chartist()

  • Pingback: Sovereign debt or jobs? | Stock Chartist()