Rolling your hedges in Up Markets

by Wayne Ferbert on February 14th, 2012

Fast moving markets that are going up are not that great for the bullish Buy and Hedge investor. Don’t get me wrong – you still make money. But when you are hedged in bullish positions, you would prefer steady upward moving markets.

Being hedged is like having insurance – so it is not free. To help de-fray that cost, we often sell away our upside in the near months. We do that deploying either the collar tactic or the spread tactic. When we use those tactics, we have effectively given up some of our upside in exchange for some premium to offset our downside.

When we sell away our downside, we usually try to sell it in the near month – when the time premium expires the fastest. Time premium that expires is good – when you have sold it. You hope it will expire worthless – but just barely worthless.

So far, in 2012, the bull is rearing his beautiful head. We like up markets. In general, we are long-term bullish investors. Our positions are making money. However, the last month was a sharp move up. So, some of our positions have some upside value that we have given up. In other words, in our collar tactics, our calls are in the money. In the case of the spread trades, the upper bound strike price of the spread has been breached.

Look at a few of our favorite positions since the last expiration in January:

Symbol Price +/- in %
SPY $134.86 +2.2%
MDY $176.65 +4.4%
XLK $28.11 +5.0%
EEM $43.24 +4.5%
XLE $73.65 +3.22%

More than likely, with expiration coming this Friday, you are ok on your SPY & XLE positions. However, back in January, the premiums you could collect to sell the upside in MDY, XLK, & EEM were not that high. So, you might have sold some upside at lower than usual strikes. Which means that you might have an ITM call set to expire in a collar hedge on one of these on Friday?

What to do as the hedged investor? Do you look to roll now? Or roll on Friday? Take a deep breath and remind yourself you have a few more days here. Unless you have a very strong feeling that something is going to happen in the market to the upside between now and Friday, I recommend you wait and see if the market might re-trace itself. You are almost certainly only a little bit in the money on these positions – so it’s probably worth waiting.

Remember, we don’t try to time the market! Timing is a short-term strategy. We are playing for the long haul.

Hedging is best deployed as a long-term strategy. The longer the time period you look back on, the higher the probability of a sharp decline in the market. If you read our book, you know that the markets have regular – and often vicious – corrections. Hedging in those time periods will almost always yield enough alpha to make up for a decade of difficult investing decisions. Remember that lesson!

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