When You Get that Pullback You Were Waiting For

by Jay Pestrichelli on January 30th, 2012

Over the last few months, the market has been on a nice bull run setting higher highs and higher lows showing us an uptrend is forming off the volatility we saw in August. If you enjoyed the run up and even got into cash last week when you thought it peaked, you’re probably feeling pretty good.

While we don’t try to time the market at Buy and Hedge, we recognize there are times to follow Rule #4: Unleash Your Inner Guru. No-we aren’t suggesting you disrobe and run around the office scaring your co-workers. We are talking about making some idiosyncratic bets on those stocks or sectors you’ve been waiting to get a little cheaper.

What does it mean to follow Rule #4? It means 2 things, you’ve already identified the sectors or stocks you’ve shown success with trading, and it also means you’re hedged so you can take emotion out of the equation. If you’ve been able to figure out your investing strengths and you take a measured risk, then you may be trying to hop into the market this week.

Let us make a suggestion here on how to do it…look into using in-the-money calls as a stock replacement. Option prices are cheap on a relative basis right now, so getting long calls will have a low time component. We like to measure the “priceyness” of options by watching the implied volatility of the broad market, AKA the VIX index.

When options are cheap it’s a good time to go long. This applies for your hedges as well, but lets stay on the calls. Consider long calls, 6 months out if you can, to create a synthetic stock exposure. Keep the time value to somewhere between 2-4% on an annualized basis and might be able to get into one of those stocks you’ve been watching AND be hedged all at the same time.

Why is an ITM Call hedged? The answer is because it has a floor on its losses. It also has the same volatility and leverage as just being long stock, but allows you to experience the gains and losses as if you bought it outright. Yes, you have to consider the break-even mark to offset the time value, but consider that the price of your hedge.

As we outline in our book and in the calculation worksheet, know your metrics and determine the limits that work for you.

Happy Hedging!




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