Re-investing your hedged profits is the key to Compounding!

by Wayne Ferbert on May 21st, 2012

The market pullback in recent weeks reminds us that markets don’t keep going up. The markets had tremendous momentum: two straight quarters of +10% returns. But the market cannot move up forever.  These weeks remind us that markets correct regularly and when they do, the correction is usually swift.

Last Friday was options expiration for the month of May. You might have had protection that you purchased that expired. If you bought that protection 6 months ago, it probably did not finish in the money given that markets are up compared to November and December levels.

However, maybe you did have a protective hedge that was in the money that expired on Friday? If you did, then it is time today to re-invest the profits from the hedge.

I had a very interesting conversation with a client of our advisor firm (ZEGA Financial) last week about the importance of re-investing the profits from your hedges. Remember that the hedge is the position that fixes your loss at a set downside. When the market moves thru that downside level, your losses stop even if the underlying keeps moving down.

You MUST re-invest the proceeds at the new lower price of the underlying now to get the benefit of BOTH the market recovery and the power of compounding. In fact, ideally you did it last week before the expiration on Friday.

Here is the math so you understand it. Let’s say you own a broad market ETF that you bought for $100 back in November. Let’s say you buy a put back in November also with a strike price of $90 that expires in May 2012. So, your downside floor is $90. Now, let’s say that last Friday at May expiration, the ETF was trading at $80. Your put is going to trade at $10 on the day of expiration. It has intrinsic value of $10. You stopped losing money at $90.

If the put was exercised on Friday at expiration, you would be sitting with $90 of cash today as your ETF would have been sold for $90. However, you would not be invested in the market since you would no longer own the ETF. You need to take the $90 and buy shares of the ETF again. The ETF was trading for $80. So, you can now buy 1.125 shares of the ETF.

If the ETF recovers back to $100 price, you would have a $112.50 worth of the ETF. The person that just rode it from $100 to $80 and back to $100 would just have $100.

You got your $10 profit from the hedge re-invested so it could grow. You got your money re-invested and didn’t try to time the market. So, when it recovered, you had more of it invested.

If you only reinvested back in to 1 share instead of 1.125 shares, you would be just back at $100 + the $10 you protected from the hedge. You would be at $110 instead of $112.50. What does that extra $2.50 represent? It represents the power of compounding. You got the $10 re-invested and it grew 25% with the ETF (ie, the ETF went from $80 to $100 – or 25%).  10% of $2.50 is $2.50 – that is the difference.

I know it is uncomfortable re-investing your money back in to the ETF or stock that just fell far enough to put your hedge in the money. However, markets nearly always recover after significant market shocks. Look back to 2009. The markets went from high in $1400s in S&P 500 in October 2007 only to drop to just below $700 in early 2009. Earlier this year, we were back in the $1400s again.

You need to re-invest the hedge proceeds to see the true power of compounding take effect!

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