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Posted on March 9, 2015 -
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A question facing many long term investors who are not professional traders by trade or who manage their own stock portfolios is whether or not they may be well-served by buying portfolio  “protection” (often SPY or QQQ put options) when investors determine that the general market may be “vulnerable” to a decline. They may not wish to sustain losses that exist on paper only during a correction but where those losses could be much wider should a more serious decline materialize.
 
Determining when the market may be potentially “vulnerable” to a decline is an art as well as a science. In previous blog posts, I described a few of the” high points” regarding how, why and where I hedged here and here. I have done so with reasonable accuracy. However, I am striving to capture a greater percentage of the downside moves that ensued as realized profit that occurred after my hedges.
 
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I have tried on this site predominantly to provide information to investors that may help them become more effective and profitable long term investors over a working lifetime of investing. My book addresses that interest and shares my investing journey in my Kindle e-book and on the Book page.
 
Even after considering the major bear markets of the last century and the bear markets so far in the current century, the long term trajectory of the market remains upward until proven otherwise. The fly in the ointment is that the stock market will likely be present long after everyone currently reading any article anywhere have passed away. The investor may expire before his portfolio recovers or takes off. When the investor may be in retirement years, the sustainability of the portfolio size to support him or her is crucial. Asset allocation may be helpful in potentially insolating portfolios from debilitating drawdowns.
 
If investors are able to effectively begin hedging the S&P 500 or SPY against some of the inevitable declines in the stock market with effective timing – may it not offer the investor some reasonable solace while experiencing many market declines?  Also, an undercapitalized investor may potentially make money in down markets through buying protection . One does not know in advance when a garden variety market fall may morph into a full-blown bear market.
 
As we are all part of the Federal Reserve’s grand monetary experiment, financial, economic, bond and equities markets outcomes may be unpredictable in nature or follow different paths than the past. Unless there has been a further radical paradigm shift in the financial landscape (such as the Federal Reserve losing control over interest rates), the bull market may be likely to resume after this dip. In any case, an effective hedge leaves the investor prepared for the worst should that happen.
 
 
I had the pleasure several months ago of watching via the world wide web a Barron’s magazine presentation on the topic of how Barron’s subscribers (including myself) may use that magazine’s assortment of graphs and statistics to make better decisions determining the potential direction of the equities markets and the economy.
 
 
Stephen M. Sears. states in his Monday, March 9, 2015 "Striking Price" column on page M11 entitled, "Get Ready for the Next Rally,"published in Barron's  that some investors may have missed the boat of a rising equities markets tide and instead chose to hedge their holdings by buying put options. He further indicates that this course of action hindered those investors portfolio performance. 1 (1) Steven M. Sears; "Get Ready for the Next Rally"; Barron's: The Dow Jones Business and Financial Weekly Vol XCV, No 10; March 9, 2015; page M11
 
After supporting his case, Mr. Sears states,"investors should consider calls on sectors that led the market higher in February." 2, (2)Steven M. Sears; "Get Ready for the Next Rally"; Barron's: The Dow Jones Business and Financial Weekly VOL XCV, No. 10; March 9, 2015; page M11

 
Mr. Sears obviously has the statistical resources at his disposal that a magazine of Barron’s caliber can provide. 3 (3) Steven M. Sears; "Get Ready for the Next Rally"; Barron's: The Dow Jones Business and Financial Weekly Vol XCV, No 10; March 9, 2015; page M11

 
 Oddly enough, it seems to me that the graphical evidence published next to this week’s “ column next to it seems to contradict Mr. Sears’s current advice – at least in the short-term.
 
The recent top for the SPX was on March 2nd at 2117.52 (intraday). In my portfolio, I hedged by buying SPY puts on March 3rd, the day after the interim high.  I followed up on March 4th by buying QQQ puts.  The index closed Friday March 6th at 2071.26. At this point, I have healthy profits on my hedge. I would potentially close them if SPY and QQQ trade near the bottom of 2.5% and 4% moving average channels respectively.  Should prices trade significantly below the lower band it could be an indication that the lows of the move may be retested a second time. Please see here another method to potentially determine market bottoms.
 
Since Mr. Sears is presently advising buying calls on selected sectors,4 (4) Steven M. Sears; "Get Ready for the Next Rally"; Barron's: The Dow Jones Business and Financial Weekly Vol XCV, No 10; March 9, 2015; page M11; I would chime in to say that investors may potentially be better served by waiting until the current decline probes the lower moving average band before buying calls in order to potentially profit should the uptrend resume. That could happen any day. 
 
Regarding Mr. Sears’s advice to buy calls, there are four charts next to the “Striking Price” column in each week’s Barron’s. 5 (5) Steven M. Sears; "Get Ready for the Next Rally"; Barron's: The Dow Jones Business and Financial Weekly Vol XCV, No 10; March 9, 2015; page M11; I should disclose that my knowledge of options is probably not as extensive or specialized as Mr. Sear’s but it would seem that the message of the market portrayed in the four graphs may contradict the advice he renders in this week’s column – at least short-term.
 
The first chart shows the CBOE Volatility Index and VIX Futures line chart (as cited in Barron's, 2015). In the chart, VIX futures are plotted higher than the VIX line in the graph. The VIX futures line has hooked upward. As was explained when Barron’s presented, this may portend higher volatility ahead.
 
The next chart shows the relationship between the equity-only put-call ratio and the S&P 500 Index (as cited in Barron's, 2015). This chart shows that the market seems to be closer to a top than a bottom.
 
The final two charts portray SPX Skew and NDX Skew implied volatility percentages (as cited in Barron's, 2015). A higher level in the chart indicates possible downside market risk. These two indicators have been at relatively high levels for some time. They line plots are again moving up which may indicate greater risk in the market. The Skew indicator that I follow is at 124.65 – which is a benign number. Levels above 145 are potential Black Swan territory.
 
To summarize, the market’s picture portrayed in the graphs seem to contradict the advice given in the column. When recommending option trades, entries count.
 
I would recommend that investors who wish to make a quick, uncomplicated and reasonably accurate assessment of the equities market’s posture peruse these four charts weekly. As well, viewing and seeking divergences in the plot of the advance/decline line and the market in the magazine’s stock tables is also helpful in determining a probable future course of the equities market.
 
Anything can happen at any time in the stock market. The further decline that I envisage may never happen. Or the path downward may turn out to be different than I expect. Mr. Sears’s advice, which may be constricted because of writing deadlines, may be spot-on and timely, in which case I would happily defer to him. In some sense, it is possible that his advice and my prognostication may both be right in turn. The market is greater than its players own outcome - as the market supersedes any person’s conjecture and opinion.
 
References:
1.       CBOE as cited in Steven M. Sears; "Get Ready for the Next Rally"; Barron's: The Dow Jones Business and Financial Weekly; Vol XCV, No. 10; March 9, 2015; page M11
 
2.       McMillan Analysis Corp. as cited in Steven M. Sears, "Get Ready for the Next Rally," Barron's: Thew Dow Jones Business and Financial Weekly; Vol XCV, No. 10; March 9, 2015; page M11
 
3.       Credit Suisse Equity Derivatives Strategy as cited in in Steven M. Sears, "Get Ready for the Next Rally," Barron's: The Dow Jones Business and Financial Weekly; Vol XCV, No.10; March 9, 2015; page M11
 
 

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