Protect Yourself Against An Imminent Stock Market Correction

Winning in this game we love means your portfolio out performs a benchmark index because if all you do is match the market, you might as well put your money in an index fund or market index ETF and not even go through the motions of playing. However, if you do play then beating the market when it trends up is tough and demands near perfect stock selection (pick stocks with positive relative market performance and cut losses from mistakes early). But beating the market when it trends down is easy …. if you successfully manage or avoid the downturns.

The important questions isn’t if it’s true to the Lunar cycle theory or not (last week, the market has sold off 1.6% since the New Moon and there are still seven more trading days until Full Moon on Wednesday, December 2) but where the market will be in 3-6 months and how best (i.e., with the least risk) might we prepare our portfolios to make the best advantage of whatever move occurs.

Optimistically, momentum indicators have finally confirmed that a bull market is intact since the 200-dma just recently crossed above the 300-dma. This long-awaited cross puts all the moving averages in perfect alignment, fastest on top to slowest, with the Index above them all, an arrangement I’ve dubbed a “bullish cross”. In March 2008, the mirror image of this alignment (slowest on top to fastest with the Index beneath all) confirmed the onset of a bear market of major proportions, the Financial Crises Crash. A final step to nailing down the bull market will be when the 300-dma finally turns up for the first time since January 8, 2008. Mathematical extrapolations (see my post “Mark These Dates“) say the turn should occur around December 3 (just in time, coincidentally, with the new lunar phase).

Many traders and investors believe this bull market has unstoppable momentum and has now finally gained a permanence, overwhelmed the bears and will continue for the foreseeable future. But others who look at fundamental economic and financial indicators like P/E ratios or Fibonacci guidelines (50% retracement of bear market decline) argue the market is due for a correction.

I’m in the latter camp, albeit having arrived early (see “Begin Pruning, Trimming and Weeding Your Portfolio” of October 16, “Ascending Everest: the Mid-Station Rest Camp” of October 18, “More Evidence We’re Approaching a Top of October 23 and “One View of Market’s Future” of November 9). I prefer both the simplest of momentum indicators (moving averages) and the simplest of trend analysis (resistance and support trendlines). They’ve suggested to me from the outset of this bull move in March that the 1125-1150 area could be significant because it is an area of past congestion and an area where equilibriums between buyers and sellers have ended in reversals (in other words, an area of many pivot points). There’s a strong likelihood, therefore, that the area can again produce a pivot point (why? because of market psychology and behavioral finance).

“If so, what’s our strategy”, you must be asking? How can we create some protection with minimal risk while at the same time leave room for upside opportunity in the event that our calculations are wrong? We know that the long-term momentum indicators point to further upside gains; it’s the 10-15% market correction we want to protect against. It’s at this point that the bald former football player on Fast Money shouts, “I hedge my bets through options!” Of course, he’s “selling his book”, as they say on The Street. However, this time he may just be right. What options do we have?

• “Buy and hold”: only protects against opportunity losses in the event we’re wrong and the market continues going up; but it provides no protection against real losses if the market goes down instead.
• Diversification: only a partial successes - if you select correct places to diversify into and if all asset classes don’t move in tandem as they did last year.
• Sell positions and move into cash: outstanding strategy in confirmed bear markets but a less than optimal defense in corrections because it protects against losses but creates opportunity losses if our timing is off either in getting out or in coming back in.
• Hedge positions: Bingo! Involves limited risk yet offers upside potential

Assume that you have a $100,000 portfolio whose performance moves precisely in tandem with the S&P 500 Index (^GSPC). A simple and direct option hedging strategy is available: buy SPY puts. For about 9.5-10.00% of the value of the portfolio, or approximately $10,000, you could buy ten on-the-money puts with March expiration that would insulate a $100,000 portfolio through increased option value (beyond the cost of the premium). If you were wrong and the market moved up, at expiration you would retain the increase in portfolio value offset by the premium paid for the options.

But the “insurance” premium of the options and exposure to risk can now be reduced without giving up any upside potential because of the introduction of Ultra (2X) and UltraPro (3X) SPY longs and shorts. These ETFs also have call and put options available; because these ETFs themselves are leverage, ProShares now provides the means for a more efficienct leveraged investment “insurance”. This ability of buying options on double and triple ETFs appearsto be an inequality in the market that doesn’t appear to me to have yet been arbitraged away. Rather than costing 9.5-10.0% through options on the underlying security, and equal portfolio value can be “insured” with fewer on the money calls or puts on SPY UltraShort (SDS) or UltraLong (SSO) ETF’s, respectively, for about 4.5%, half the cost. [Because they are only less than 6 months old, I have excluded the UltraPro etf's from consideration.]

Click here to download a spreadsheet summary of this SDS calls hedge strategy (with comparison to SPY puts), plus this graph:

Note that the spreadsheet is an example using data as last week when I purchased these options. Before you pursue the strategy, you should do your own analysis and evaluation for correctness and appropriateness for your own situation. I welcome comments and suggestions on why my analysis might be faulty or how it might be improved.

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