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.