WEEKLY MARKET UPDATE

The long term trend remains up.  Last week I stated that the first likely area of support was the 157.50 level which represented the October 2007 high.  What is interesting is that the market not only traded down to this level but it also traded just two ticks below the March 2001 high at 155.75 (lowest green line) just before rallying for most of the week to close higher than the previous week and more importantly, above these two important support levels.  Ordinarily I would consider this to be very bullish but when looking at this week's price action compared to previous week, the rally was not very strong.  At this juncture I would say there's a 50-50 chance that this past week was just a week rally in an intermediate term down trend.  If we get a weekly close below the lowest green line, then the 40 week moving average is the next support target at 151.38.  If we get a strong weekly up close then there is a strong probability that the May 2013 high of 169.07 is challenged.















CONCLUSION

I will continue my series of articles on hedging next week.  I was unable to put anything together this week due to time constraints.  Next week I will talk about how to lower the cost of hedging and provide a general blueprint of when to hedge.  Have a great weekend!

WEEKLY MARKET UPDATE

While the long term trend remains intact, the intermediate term trend is pointing down.  As I pointed out last week, the next likely area of support is the October 2007 high which is represented by the lower green line (see weekly SPY chart).  If the market manages to close strongly below that level on a weekly basis, then the 40 week moving average is a likely target at the 151 level.

HEDGING

In last week's post I answered the question of what type of put option to buy as well as how many to buy to properly hedge a portfolio.  This week I want to talk about what strike price to buy and how far out in time one should go:

1) What strike price to buy?  ANSWER:  This is really a function of your risk tolerance and how much you're willing to spend.  Two weeks ago I showed you an example of buying a put option with a strike price very close to the current price of the SPY (at-the-money put).  Buying this put limited my maximum downside loss to only 5.9%.  I could have chosen a put at a lower strike price (out-of-the-money put) which would have costed less, but then my maximum downside loss would be greater than 5.9%.  What you need to know is that there is a trade off between cost and risk.  If you want to cap your loss at 5%, you're going to have to pay more.  However, if you have a greater risk tolerance; say 10%...then you can spend less on an out-of-the-money option.

2)  How much time to buy?  ANSWER:  During long term bull markets major corrections may last anywhere from 1 - 6 months.  However, if you look closely at the charts most of the damage is typically done within 3 months.  Personally, one month of protection is not enough for me, but I think it's unnecessary to spend more than I have to.  For this reason I typically prefer 3 months.  But again, the more time you buy, the more you're going to pay.

CONCLUSION

Obviously there is a cost associated with hedging a portfolio.  So over the short to intermediate term an investor who does not hedge may enjoy better returns.  But the fact of the matter is that over the long run there are significant corrections. There is no question in my mind that results of an investor who does prudently hedge will outperform over the long run.  For those of you who are still hung up on cost; what if there was an option strategy that you could employ that would not only help pay for the put option while still allowing unlimited profit potential?  I'll get into more detail in future posts.  Enjoy your weekend!

WEEKLY MARKET UPDATE

The long term trend remains up.  However, as I've pointed out in my last two posts, a high probability exists for an intermediate term correction, especially after last week's price action (see SPY chart).  As you can see the market opened higher than the previous week only to close lower than where it closed the previous week.  This is very bearish price action. If the SPY next week closes below 162 the probabilities are very high that the market will correct at minimum to the 157.50 (lower green line) which represents the previous all time high made in the SPY in October, 2007.  If the market continues to correct below that level, a test of the 40 week moving average (white line) currently at 150.72 is likely.

This market is long in the tooth and overdue for at least an intermediate term correction.  As I mentioned last week, If you have been long from a much lower levels it may be wise to take some profits off the table or look at potentially hedging by buying put options.

HEDGING

In last week's post I illustrated a simple yet powerful hedge technique which involved buying simple put options to hedge a portfolio with stocks, ETF's or mutual funds.  Many of you may be thinking great, but I have the following questions:

1)  What kind of puts do I buy to provide an adequate hedge?  ANSWER:  The puts should be related to an ETF which is most closely related to your portfolio.  If your portfolio is most heavily weighted with blue chip companies, consider buying put options on the DIA.  If mostly technology stocks, consider the QQQQ.  If mostly large cap stocks, then consider the SPY.

2)  How many puts do I buy to provide an adequate hedge?  ANSWER:  The formula for determining how many puts to buy is simple.  You simply take the value of your portfolio divided by (the current ETF price X 100).  As an example, let's say today your portfolio value is $100,000 and it is most closely correlated to the SPY.  Friday's SPY close was 163.18.  Following is the calculation for the number of puts you need:

$100,000 divided by (163.18 X 100) = 6.12....or 6 SPY puts.

CONCLUSION:  Next week I'll get more into what strike price one may consider purchasing as well as how much time to buy.  In future posts I'll talk more about when one may consider putting on and taking off a hedge as well as ways to lower the costs of hedging.

WEEKLY MARKET UPDATE

The long term trend remains up.  Last week I pointed out that the probabilities favored a weekly correction that could perhaps result in a decline to the 157.50 area, which represents the October, 2007 high or could potentially drop all the way to the 40 week moving average at 150.24.  While the week started off with a decline, it rallied to close higher on Friday than where it opened on Monday.  This latest weekly bar is slightly bullish.  I still believe that the probabilities favor a market correction but last week's price action indicates that there is the potential that the May high of 169.07 may be tested first.

BENEFIT OF HEDGING

A bull market never moves up in a straight line.  There are minor and major corrections along the way which could severely impact account equity.  A minor correction of 5% would not be difficult to recover from but at a 10% loss you need an 11.1% return to get back to break even.  A 20% loss you need a 25% return to get back to break even.  Things start getting progressively worse once you lose 30% or more.

What if you could employ a simple hedging strategy where you could dictate exactly how much you're willing to lose, even if you stayed 100% invested during a market crash or long term bear market?  Today I'm going to show you a brief illustration of how buying a simple put for protection could have benefited you during the most recent major market correction where the market lost 15.7% from 5/3/2011 to 10/5/2011.  Let's compare the results of Investor A vs. Investor B during this time frame.  Both decide to purchase 100 shares of the SPY at 135.73 on 5/3/2011.  Investor A simply decides to buy and hold but Investor B decides to hedge his position by buying the a December 2011 put option at the 135 strike.  Following are their investment results as of 10/5/2011:

Investor A initial equity is $13,573 (100 shares * 135.73).  The value of his investment on 10/5/2011 is now $11,442 (100 shares * 114.42).  His equity during this decline has lost 15.7%.

Investor B initial equity is also $13,573.  Like Investor A; his stock equity is also $11,442 as of 10/5/2011.  However, the put option that he paid $835 for on 5/3/2011 is worth $2,170 on 10/5/2011.  His total equity is now $12,777 which represents the stock equity minus the cost of the put plus the current value of the put (11,442 - 835 + 2,170).  His equity during this decline has lost only 5.9%.

CONCLUSION

This week I've only shown a basic example of hedging.  But as you can see even a simple hedge can provide you with significant protection during severe market declines.  In the weeks to follow I plan on addressing how one might hedge a 401-K plan as well as IRA's.  Have a great weekend.

WEEKLY MARKET UPDATE

On a long term basis the market is still very much in an up trend based on the four factors I pointed out in last week's post.  As I also pointed out last week there will be several weeks where little comment is necessary on the long term signals since they are so infrequent.  Therefore, for the most part the weekly updates will be focused on identifying high probability intermediate term market corrections.  

The tools that I use for this purpose are the weekly SPY chart with a 40 week moving average (see attached).  I also use the same sentiment indicator (not shown on chart) that I use for determining the longer term signals.  As of the close of this past week my analysis points to a high probability of a market correction with potential support targets of 157.52 (October 2007 high) with a potential for the market to drop all the way to the 40 week moving average (white line) at 149.65.  Following is the analysis:

1)  The market is trading at a level above the 40 week moving average which is historically related to significant market corrections.

2)  If any of you are familiar with japanese candlestick analysis; last week was a doji bar which closed lower and this week closed lower with a bearish engulfing bar.

3)  Sentiment (not shown) is rising from historically low levels.

If one is fully invested in mutual funds in a 401-K or IRA, there are two things you may want to consider.  1)  Based on your risk tolerance move a desired percentage into cash.  2)  Consider hedging your position with put options.  In next week's post I'll start getting into more detail about basic hedge techniques that can be used to allow one to stay fully invested during longer term up trends while significantly reducing the portfolio drawdown during intermediate term market corrections.  Have a great weekend!