Tuesday, 26 October 2010
Remember the old adage that it is much easier and cheaper to buy insurance when the weather is good as opposed to when a tornado is coming down your street?
Here’s a lesson I learned quickly in my early days as a trader:
Professionals almost always have a “hedge” or some form of protection just in case things go wrong. A hedge could be as simple as diversification or an option strategy like a covered call. Hedges can also be done with hard assets like real estate or numismatic coins.
“Hedge” funds are very actively managed and invest in all sorts of assets to try to provide exceptional returns for their investors and minimize volatility when things go south in the markets.
When I was a trader on the floor of the stock exchange, I almost NEVER took on a position without having a full or partial hedge to protect it.
But hedging isn’t just a tool for the pros. You could (and should!) be implementing this technique too, especially now. Here’s what you need to know…
An Easy Example
If I were long 1,000 shares of Apple and thought the market was looking a bit overbought, I might sell 300 shares of the SPY to lower my trading account’s overall “volatility.” In other words, if I am still bullish on Apple and don’t want to sell my Apple position, maybe for tax reasons, my short SPY position helps to buffer my account when the market sells off. I will still make money when it goes up.
Here is what a hedge looks like:
Long Apple Stock Alone:
Apple is down $1 — my account would be down $1,000 (1,000 shares)
Net result is a $1,000 loss on that day
Long Apple Stock With Short SPY Hedge:
Apple is down $1 — my Apple investment would be down $1,000.00 (1,000 shares)
Short SPY might be up $1 — my SPY investment would be up $300 (300 shares)
Net result is a $700 loss on that day (30% less of an overall loss)
See how a basic hedge works?
Of course, this is a simplified version and I don’t recommend you go out and short the SPY or sell a bunch of stock short unless you know what you’re doing. Remember that hedging may also slow down your profits, but you can remove hedges as you see fit.
Also remember that shorting stock can be an extremely risky proposition, but at least you can consider the method and in this case, you won’t have to short anything.
(Sign up for Smart Investing Daily and let me and my fellow editor Sara Nunnally simplify the market for you with our easy-to-understand articles.)
Protect Your Long Stock Positions Now, Without Going Short or Selling Anything!
Since the dollar has been driving the majority of the rally in stocks and commodities (gold and silver included), chances are that a good portion of your investments are going to be sensitive to a change in direction in the dollar, or more specifically, a dollar rally.
Don’t worry; you don’t have to go and short the dollar in the Forex market!
There is an ETF called the PowerShares DB US Dollar Index Bullish (UUP:NYSE), which is a bullish dollar ETF (if the dollar is stronger against other major currencies, the UUP will rise in value). As you can see from the chart below, the UUP has been moving in direct contrast to the SPY. This makes for a good hedging vehicle.
So What Do You Do?
Consider allocating 4-8% of your higher-risk investments (stocks, etc.) into the UUP. If the market continues to rise, you may not make as much as you would if you did not have this investment. However, if the market begins to retreat from a dollar rally, you will not lose as much, as your UUP investment will grow.
For you option traders out there, you can also sell covered calls on your UUP position; this will help not only reduce your cost basis, but will help when the dollar remains weak!
These are some unique and slightly advanced tactics, but if you want to trade like a professional, you must learn to think like one!
P.S. As soon as I joined up with the Taipan Publishing Group, I quickly learned that another trader here shares a similar style to me. Adam Lass not only has a love of charting… but also frequently utilizes hedging techniques in his services. If you want some more extensive education on hedging like a pro, I suggest you follow Adam’s latest service. You can watch a short video right here, explaining all the details.
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Other Related Topics: Hedge Funds , Jared Levy , Options Trading , Smart Investing Daily , Stock Market
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