Learn How Placing a Small Hedge Can Pacify Your Seemingly Irrational Worries

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By Greg Jensen

Sometimes, you look at a particular market and it just feels like something is going to happen. Feelings and emotions are generally a terrible basis from which to trade and invest. Hard numbers work much better. Often though, that nagging feeling at the back of your mind alone can adversely influence your decisions. In that case, placing a small trade that you feel is right may be a good idea. Once you tell yourself that you have done something you can go back to sound reasoning.

Since the beginning of this year, the U.S. stock market, as represented by the S&P 500 chart above, has given me one of those nagging feelings. There are few, if any, logical reasons to expect a pull-back in the near future. The economy is continuing a recovery, albeit slow, corporate profits are still good, the housing market is recovering and, maybe most important of all, the Fed is still pumping money into the financial system through QE. Call me a pessimist however, but when everything looks good, I start to get worried.

This week’s price action has me worrying all over again. Monday's losses were just that, Monday’s. The lost ground was quickly recovered on Tuesday, indicating a legion of buyers looking to buy on dips. This is a very positive sign, but history tells us that when everybody in the market is thinking the same way, trouble is coming.

I should make it clear that I am not laying out a bear case here. There really isn’t a convincing one at the moment. I am simply talking about suppressing that nagging feeling that things just look too good. In this situation, placing a small hedge can pacify your seemingly irrational worries and allow you to think more clearly going forward. So, if you are of a like mind, what are the strategies you may consider?

  1. Buy Some Bonds: Let's get the worst idea out of the way first. The traditional hedge for an equity portfolio was to diversify by adding fixed income products. This strikes me as a particularly bad idea right now. If there is to be a problem for markets in the near future, it looks far more likely to be triggered by bloated government debt around the world than anything else. If the economy were to slow down for any reason, bonds and stocks could well fall together. Even if this doesn't happen, the percentage of your portfolio that you would need to dedicate to fixed income would make this prohibitive for most active investors and traders.
  2. Buy VIX Options: As an options guy, this is one of the first things that occur to me. The “fear index” is certainly at low levels. Calls on the VIX are, by their nature, leveraged, giving the possibility of recouping a good percentage of any losses should a correction occur, without risking an enormous amount. Just buying naked calls, however, has a huge downside given that you are looking to protect against the unlikely. You are really buying an insurance policy and, should the upward march continue, your calls would expire worthless and you would lose all of your hedging money.
  3. Buy A VIX ETF/ETN: On the surface, a derivative of a derivative on derivatives would seem to be too complicated for most and something to avoid. If you understand the downside, however, this may be the best option for buying a little peace of mind. Fixed allocation funds that try to duplicate the VIX, whether leveraged or not, are not good long term investments. Problems with contango mean that they will inevitably lose value over time. As short term protection against a nagging feeling, however, they work well. Knowing that you own something like the iPath S&P 500 VIX ST Futures ETN (VXX) that will respond quickly and violently to a collapse can do wonders for frayed nerves. Leveraged versions such as VelocityShares Daily 2x VIX ST ETN (TVIX) are available, but are better suited to a very short term play when you are convinced a collapse is imminent.

 

If you are a worrying kind and that worry bothers you, then buying some kind of hedge may help clear your head. If, on the other hand, this is a genuine bull market, the best advice may come from Bobby McFerrinn, "Don't Worry, Be Happy."

For the OptionsAnimal Best of 2013 Stocks and ETFs Report click here. It’s FREE.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Options , ETFs , Investing Ideas

Referenced Stocks: TVIX , VXX

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