Letting your market outlook guide your market hedges

by Wayne Ferbert on October 9th, 2012

It has been a year now since our book was published and we introduced the concept of “Buy & Hedge” ™. It has been a fun year and by working with readers and clients, we have learned even more that has allowed us to advance the concept even further.
If you have followed the Buy & Hedge approach this past year, you have probably never had a downside hedge finish in the money. After all, it was at this time last year that the market started to turn around and began an impressive one-year rally. When markets are going up, hedges tend to expire worthless. That outcome is ok since you are long the underlying stock or ETF and enjoyed the run up also.
But now after a one-year market rally in which no hedges were needed, you might ask yourself: does hedging really work? The answer is hedging works for what it is INTENDED to work: protecting your portfolio from a strong down market.
The last 12 months have been the opposite of a strong down market – it has been a strong up market. But we look to hedge all of the time because we don’t know when that strong market down-draft is coming.
We aren’t trying to time the market. If we knew EXACTLY when the strong down-draft was coming, we’d get our money out of the market and even go short the market. Then, we’d profit in any market. But knowing when the market is going to turn is a difficult business to be in.
The Buy & Hedge approach is meant to be an all-weather portfolio approach that doesn’t require you to watch the market every day to be able to be effectively invested and protected.
But if you do watch the market closely and have a market outlook, then you can use that outlook to customize your hedges for your specific view.
Think about these three outlooks:
(1) You think the bull market will continue to run up;
(2) You think a market pullback is likely in the near-term;
(3) You think the market will be range bound and move mostly sideways.
If you think the bull market will continue, then you should try to reduce the cost of your hedges. You can do this in several ways but the most common ways are: (1) buy protection at even lower levels so they cost less; (2) only buy protection for 70% of your positions (ie, for 1000 shares, you would only need 7 put contracts). If you are using collars, think about still selling the covered calls on 100% of your portfolio – but maybe adjust to higher strike prices to give your portfolio more room to run.
If you think the market pull back is likely, then keep yourself 100% hedged. And as hedges expire, re-set them to higher protection levels. In other words, get your protection levels ready for the pull back. Think about selling the covered calls in your collars at lower levels. And if you really think the pull back is imminent, take some profit off the table. Reduce some of your positions – and roll that profit in to a new asset category that you like. And if the only position you like is cash, then so be it.
If you think the market will continue to be range bound, then you still want to think about ways to generate extra premiums to help with the cost of hedging. One technique would be to sell OTM puts on stocks or ETFs you like at prices that you would be happy to own them. You could even look to sell OTM puts on the ETFs that you have in your asset allocation strategy. Just be ready to potentially get triggered in to owning the stocks if markets move back.
Don’t forget, in the Buy & Hedge approach, you can adjust your hedge structures to fit your market outlook.

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