By John Reizner |
I recently remarked that the uptrend had resumed in the S&P 500 e-mini stock futures (albeit a weak uptrend) after emerging from a minor low on December 16th at 1961.50. The e-mini then rose to 2088.75 on December 26th before falling to 2046.25 at the close on January 2, 2015. I address in this essay whether a put option hedge may help investors potentially protect their portfolios from a decline in stock prices at this juncture in the stock market.
The December monthly candles on the S&P e-mini and on the SPY exchange traded fund monthly charts are harami candlesticks: a formation that may indicate key reversals in these markets. A major reversal of the long term uptrend in equities is possible if the monthly candle formations are valid. A harami cross appeared on the Dow Jones Industrial Average December monthly chart.
There is now evidence that there may be a potential continuation of the current minor washout in the market. The washout may or may not develop into a greater downtrend.
I use the early onset trend detector, created by Alexander Elder, among other indicators to determine whether an uptrend is potentially terminating and whether investors may do well protecting a portfolio of U.S. equities by implementing a put option hedge. The indicator simply renders either a buy or sell signal on an index or equity based on whether the trend is ending or beginning.
The onset trend detector successfully signaled the September/October and December 2014 declines and has rendered a “sell” signal on the S&P e-mini on Sunday evening January 4th and previously on the QQQ. I like the straightforward nature of the signal on this indicator. As the market has become more volatile in recent months, the signal’s potential reliability has increased.
While my last attempt to profit by hedging was a wash – there is always another day to hedge. No stock market uptrend, not even the one that American investors have experienced for the last six years, goes up in a straight line forever. Corrections and bear markets cannot be avoided – and they are as inevitable as the business cycle.
The MACD histogram (the MACD is a trend indicator and momentum indicator) demonstrates bearish divergences on the e-mini and SPY daily charts (rendering a short term bearish crossover on January 2nd). The indicator’s message is that the stock market has been moving up on decreasing momentum and that the uptrend is not confirmed by underlying price momentum.
On December 31, the QQQ exchange traded fund (that tracks the technology laden NASDAQ 100), gave a similar MACD histogram sell signal (the QQQ also recently traded within two points of overhead resistance last achieved during the dot-com bubble in 2000 – an important marker of overhead supply and an impediment to further QQQ price increases.
The MACD signal line’s position above or below the zero line denotes a market’s primary trend. Its position on the daily S&P e-mini and SPY is above zero - demonstrating a primary uptrend in those markets while the histogram shows secondary downside momentum. If the signal line crosses below zero, the primary trend shifts to down according to that indicator for the given markets.
Decreasing MACD histogram momentum in the S&P 500 in the daily, weekly and monthly time frames shows a syncing of bearish momentum among the three time frames (time frame convergence). Bearish time frame convergence offers the potential for a greater move down in price within the context of the primary uptrend that is still in place for now. The primary trend can change of course.
Should the stock market follow through on the downside, I would look for a two standard deviation volume histogram bar on SPY, the e-mini, etc. to determine a potential bottom’s range to close out the hedge as explained previously here. If I am wrong, I will close the hedge rather quickly.
The longer term trend in the stock market remains up as of this writing, so should a further decline materialize, it may be short-lived. The beauty of a hedge is that investors may keep it as long as needed in the event a more serious market fall unfolds.
I bought SPY and QQQ put options on January 2. 2015.