Technically Hedging

by Jay Pestrichelli on June 4th, 2013

As long-term hedgers, we typically don’t use technical analysis as a means of entry into new positions. But we do use it to get a general bias of the market and to help us define some of our hedging limits.
 
I guess one could consider our cost of hedging calculations as a means of using technicals. That calculation uses option pricing data, volatility, the time to expiration, and derivatives like probabilities to kick out which strikes best meet our downside percentage and risk tolerance.
 
However, more traditional technical analysis utilizes momentum indicators like RSI or Stochastics along side chart patterns. And although these are not tools we utilize when deciding how to allocate or when to enter and exit the market, they do provide some visibility we find valuable.
 
Using the S&P 500 index (SPX) here is what we’re seeing.
 
  1. The market continues to be in an upward moving channel that is about 80 points (5%) wide.  This trend of higher highs and higher lows is the hallmark characteristic of bullish sentiment.
  2. The 50 day moving average has proven to be a support level since the beginning of the calendar year. Right now that level lines up exactly with the upward channel support and has a level of about 1600.  Incidentally, that level seems to also be a level of previous resistance that will turn into support.
  3. If the market does break down through the 1600 level, the next support would be around 1540 as defined by March and April lows.
 
Those 3 points are illustrated on the chart below:
At a high level, we would not consider this to be a doom and gloom story. Actually, a technician would consider this clearly bullish. However, the choppiness of the market these past 10 days may lead to higher volatility and the believe that this run is over.  Formulate your own opinion here.
 
For us, the up trend hasn’t broken yet, so leaving upside exposure is desired. But even more important is limiting our downside risk and hedging incase the break comes fast and the mid-year months see negative returns as they have historically done.


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