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Hedging Long Positions
The Smart Profits Report: Issue #315
Wednesday, June 7, 2006
Hedging Your Long Positions: “Putting” More Money Into Your Portfolio
by Steve McDonald
Advisory Panelist, Mt. Vernon Research
The bears must love this market…
We have two unpopular wars and another highly combustible situation brewing with Iran; inflation is raising its head for the first time in years; the Federal Reserve is threatening to raise interest rates another 0.5% to combat it; and oil prices are doing their usual yo-yo routine.
For the past several weeks, I’ve been studying the market closely, wondering what it’s going to take for the market to drop even farther than it has recently. Just yesterday, the Dow dipped back down under the 11,000 level - and it seems to me that the herd is just waiting for the right time to send the market over the cliff.
The good news is that this is the perfect time for hedging your long positions…
Minimizing Portfolio Damage With Hedging
If you’re like most investors, the majority of your portfolio positions are long in stocks and calls. You’ve bought a good company, you’re riding out the inevitable ups and downs in the market, and ultimately benefiting from its long-term upward movement.
But hedging minimizes the damage those “downs” can cause along the way…
Hedging simply means buying put options on your current long positions. By doing so, you give yourself a profitable safety net to offset the downside blow when the market takes a tumble.
Let’s take a look at the Dow’s one-year chart, including its 50-day and 200-day moving averages. (Note that from October 2005 until the first week of May, the index rose almost straight upward.)
Once the Fed started talking about raising interest rates again, and oil prices jumped above $70 per barrel, the dip started. If you follow the 200-day moving average (in green) to the point where it intersects the price (in blue), you’ll see that the most likely stopping point is somewhere around 10,700.
Take a look at the one-year charts for your current holdings and see if any of them have the same dip.
The chart of Alcoa (NYSE: AA), for example, is almost identical to the Dow’s, and the stock will most likely follow the market down.
The logical thing to do here would be to buy a put option to benefit from what appears to be an inevitable drop. Here’s how you could do that. (Note: This is not a recommendation, just an example.)
Hedging Your Long Positions With Put Options
- Alcoa is currently trading around $30.60.
- The October $30 put (AAVF) is priced at $1.95 per contract.
- So, for every 100 shares of stock, we could buy a put option for $195.
As the underlying stock drops toward $30, the option price goes up and you make some money, while still holding the stock for the longer-term.
This is a simple - yet powerful and profitable - strategy. But keep in mind that if the market reverses course and heads higher, you could lose some - or all - of the $195 you paid for the put. But if you monitor it, you should be able to limit your loss. Remember, you cannot lose any more than what you paid for the option.
With all the current negative pressures surrounding the market, we’ll be lucky if the market does indeed stop at the upper 10,000s. Of course, if you’ve followed the markets for as long as I have, you know there’s a possibility that it won’t. So, it stands to reason that learning to develop a downside awareness will make your life a lot easier - and a lot more profitable - during the inevitable downturns.
Good investing,
Steve
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Today’s Smart Profits Cribsheet
- With the stock market hitting the skids of late, now is a great time to protect your investments. Find out how to develop a downside bias and profit when stocks go up or down by taking a look at Smart Profits # 311, Investor Sentiment & Market Behavior: Seven Tips For A Profitable Downside Bias.
- In today’s issue, Steve mentioned that buying put options could also make you money in a down market. Take a closer look at “put options” or “LEAPS” in the Smart Profits Glossary.
Related articles:
- Put Options: Why Short a Stock When You Can Buy a Put?
- LEAPS vs. Stocks: How to “Own” Almost Any Stock for Pennies on the Dollar
- Trading Short Term Options: A System for Reading the “Market Weather”
