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!