Hedging

Manage
21

Wow! Thanks for all the replies to my query! I am truly humbled by the level of intelligence on this forum.

I admire those favoring the “stamina” approach to a better return, by sticking with their ports, steadfastly, through poor market climates, employing their ability to reign in their emotions, while letting their powers of logic and analysis rule their minds, even under the most trying circumstances.

Like Steve and Charles, I am not looking to optimize gains by hedging and/or timing, but rather to make the sailing a little smoother through the troubled waters of market downturns. I don’t lose sleep when the market sucks, but can be pretty miserable when I’m awake, which sometimes that leads to finding distractions in other areas of my life, thereby ignoring my investments, because I don’t like to get upset over bad news. So, the appeal of hedging is to take the sting out of downturns a bit, avoid misery, and the inclination to find distraction, which tends to follow, thereby enabling me to maintain my focus on my investments. The “buy and hold” approach has not always been good to me. Remember Lucent, the old AT&T(love those reverse spilts!), and Applied Materials?(to name a few).

Anyhow, Charles, you said you are 50% hedged at all times. Does that mean for every $100,000 invested, you buy $50,000 worth of inverse ETFs or short exposure? Or, if you use ultrashort ETFs, how much invested in those would give you a 50% hedge. The same question goes to Steve, i.e, if you wanted a 50% hedge, how much would you invest in Ultrashorts to hedge a $100K long position?

Carl, your approach to diversification through low correlation of ports is a fascinating idea. When you shorted with the inverse Russell2000 ETF to create a 30% hedge, does that mean $30K was invested in that ETF for every $100K in long positions?

I resisted the urge to hedge a week ago, and am glad of it, since the last few days certainly have changed the market’s outlook. On Friday, the Dow finally had a breakout through resistance at 12,750. I am hoping Friday’s breakout indicates the start of a good, long rally. Two or three months of a sunny, up market, sure would be nice. And would give me time to work on a hedging/shorting strategy for the next downturn . [;)]

Thanks, again!

Jaybee [:-B]

22

John -

In theory, for a 50% hedge you would want to hold $67000 investments and $33000 Ultrashort. But in reality the Ultrashorts do not produce 2x the market it is hedging. Perhaps 1.4x. But if you are just trying to reduce the sting then 66%/33% would be OK.

I like to look for a hedge that doesn’t act as a drag . For instance, last summer I was hedging using Ultrashort Real Estate (SRS). SRS had been rising for the entire year and it was apparent that the real estate market had not come close to bottoming. Once the credit crunch started I switched to hedging with the Japanese Yen. It was a near perfect hedge for the stock market (-0.8 correlation). As the carry trade unwound the Yen rose. I liked the Yen as a hedge because it had gone up by 8%?? over the year.

So you don’t necessarily have to use an Ultrashort stock market hedge. There are often other hedges you can use that don’t reduce your profits as much.

23

Hi John,

Using your numbers, the $30,000 short positon is created by actually selling short IWM. The broker will put the cash proceeds in your account where they will earn interest (InteractiveBrokers does this).

Some other hedging approaches mentioned required purchasing an “inverse” security. In this case, you are using capital to acquire a long position in a security (that behaves inverse to the market), as opposed to shorting.

For example, 100K long, 30K short, and you have a 70K net long position with only 70K invested.

100K long, and 30K in an ‘inverse’ security, and you have a 70K net long positon, but with 130K invested.

The reason folks choose inverse securities include among other things restrictions on IRA accounts, or a broker that won’t pay interest on short proceeds (and I’ve heard of brokers who actually charge a net interest!), or perhaps a discomfort with actually shorting.

I always short in a taxable account, even if what I am hedging is in an IRA account. My expectations are that I will, over time, lose money shorting and so I want the tax write-off. Maybe some day I will be good enough to make money shorting, but that day is not here yet. Until then, hedging is the insurance premium I pay to let me sleep well and stay invested in the markets. (BTW, someone mentioned earlier they had used puts to hedge but stopped because the premiums rose to be too high - same thing happened to me).

Carl

24

Hi,

Be careful with this, hedges are needed the most when things are going well. I am hopeful that the worst is over but from a technical perspective the trend is still down and has now rallied up to resistance, but not broken through.

I have seen a number of studies that document persistence of trends among asset classes, and the persistence is actually stronger in the weakest asset classes. In otherwords, if you short the weakest ETFs, or buy the strongest inverse ETFs you have a positive expectation of profit and generally some negative correlation to the overall market. Even if profitable this is still likely to be a drag on a portfolio, so I target about 25%.

Don

25

I like to use equal parts of the SDS and QID, Ultrashort S&P 500 and NAZ 100. If I sense the need for a downside hedge I find that with an allocation of 15% (7.5x2) of the ETF’s, raise 15% cash and stay 70% long equities I usually experience protection to one-half the move, of course I give up one half of the upside as well.