I got a few questions about the volatility hedge strategy that I mentioned yesterday that provoked a few thoughts I thought might interest you. The first thought is that there is no need to go all the way to 50% hedged with XVZ (and 50% long) when our market risk indicator signals. I personally use a large hedge when it signals because the indicator is designed to warn of an acceleration to the downside. As a result, I’m willing to give up some upside gains on whip saws for the chance of making money if the market falls rapidly…and volatility rises. However, I recognize that you may have different goals than mine so here’s a performance chart that shows varying sizes of the hedge. Notice that a hedge below 20% (80% long and 20% XVZ) would have resulted in the portfolio continuing to fall with the market during the 2008 financial crisis. However, during a large swift draw down a 20% hedge with volatility was enough to protect the portfolio
Here’s an update of a post I did back in May where we showed how a volatility ETF (XVZ) can be used as an easy way to hedge when market risk is high. I use our Market Risk Indicator to signal that there is a high risk that the market is going to accelerate to the downside and an appropriate time to hedge. This creates a simple hedge strategy for long term investors. The nice thing about this hedge is that our risk indicator doesn’t signal often so changes to the portfolio are few and far between. For example, from July of 2004 (as far as my XVZ data goes back) until July of 2007 there were no signals. When perceptions of risk get high our market risk indicator tends to signal more. From July of 2007 until September of 2008 there were several signals as the housing and banking crisis was coming to the attention of investors. During 2013 the indicator didn’t signal which made for easy investment and
The past fifteen years have been a very volatile time for the stock market. Not only has the market had large corrections and bear markets it has also had huge rallies and bull markets. These swings have made and broken many portfolios. An investor can limit the violent swings in their portfolio by implementing a hedging strategy designed to limit downside losses. With the explosion of ETFs over the past few years there are now several investment vehicles that can be used as a hedge against extensive declines in the stock market. One method that is gaining popularity among investors is volatility. The most common measure of volatility is the CBOE S&P 500 Volatility Index (VIX). When an investor buys a VIX future or option they are placing a bet that the variance or deviation in the price of the S&P 500 Index (SPX) will increase at some point in the future. Basically it is a bet that the market will experience large price swings. When the stock market declines
Our core market health indicators deteriorated enough this week that we’re raising cash in our Long/Cash portfolios. They are both now 80% cash and 20% long. Our hedged portfolio is now 60% long (stocks we believe will outperform the market in an uptrend) and 40% short the S&P 500 Index (either short SPY or buy SH). Our measures of the economy slipped from -7 to -8. The economy measures continue to disappoint us as they just can’t seem to get a footing. They went negative near the first of December, got all the way down to -10 (our worst reading), moved back up to -3 at the beginning of February then turned over again. This indicator usually has a pretty good lead time at both bottoms and tops so the fact that it has kept a portion of our portfolios under invested for almost three months gives us concern. Our measures of risk dropped a bit this week to +5. There still isn’t much concern from market participants about a
Enough of our core market indicators strengthened today to add more long exposure to our core Long/Cash portfolio. The core portfolio is now 60% long and 40% cash. Our other portfolios are still 100% cash or aggressively hedged since 10/19/2012. One thing of note is that our core market health indicators are reflecting the uncertainty in the market. Since the beginning of August they have had eight major signals. All of them have been between 1395 and 1430 on the S&P 500 Index (SPX). We’ve basically put on some longs then raised cash at almost the same level over the past five months. Now we’re adding exposure again…in the same range. The discrepancy between our Core portfolio and our other portfolios gives us concern. Usually we see our Market Risk Indicator looking better when we add exposure to the Core portfolio. Right now we’re seeing risk rising at the same time as the underlying market is getting healthy. This is one more sign about the huge uncertainty in the market…and
We tightened our hedges in our Long / Short hedged portfolio today. Some of our longs were getting away from their hedge so we brought them closer together. As I’ve noted on Twitter @DownsideHedge, our core market health indicators are strengthening this week, but our market risk indicator refuses to come in line. That leaves us aggressively hedged even though we’re seeing underlying health in the market. A further rally (and resolution of the budget negotiations in Washington) will most likely improve both our core health indicators and our market risk indicator. As a result, good news that is accompanied by a rally will most likely move us from aggressively hedged to a large long exposure all at the same time. Nevertheless, we’ll continue to follow our discipline and wait for a signal before making any portfolio adjustments.
We’re seeing more weakness in our Core Market Health indicators this week. As a result, we’re moving to 60% cash and 40% long in our Core Long / Cash strategy. As we noted yesterday, we don’t know where the market goes from here, but market internals are telling us to take caution and protect our portfolios until the internals become more healthy. Here is more information about how we hedge by going to cash. Our hedge strategies that use our market risk indicator went to cash or were aggressively hedged on 10/19/2012. The cash strategy is benefiting, while the aggressively hedged portfolio is currently paying for insurance as the time decay and lack of volatility are eating away at our hedges. Even with the small loss in the portfolio we’re comfortable with our current positioning especially since it doesn’t appear that anyone is looking at the headwinds we’ll face next year regardless of the fiscal cliff resolution. On the chart below the yellow lines are us raising cash. The thickness
Today we find ourselves watching a market that is in no man’s land. After topping in mid September the S&P 500 Index (SPX) suffered a mild correction falling from about 1475 to near 1350. Now it is attempting to rally and is caught between its 50 and 200 day moving averages. Everyone seems to be asking the same questions. Have we topped? Is the bottom in place? Where does the market go next? With that in mind, we thought it would be a good time to talk about a few of our most important observations about market tops over the last 30 years. The first thing we’ve noticed is that tops take a long time to form. They’re brutal to an investor who makes big bets using put options because of the time decay in their options while the market chops around, puts in marginal new highs, then chops around some more. Fortunately they’re a bit less painful for an investor using put options, volatility, or other aggressive financial instruments
Here at Downside Hedge we’re always interested in any hedging strategy. Although we’ve developed our own criteria for when and how we hedge our portfolios, we try keep abreast of ETFs and Mutual Funds that offer hedging strategies to individual investors. We understand that there are individual investors that aren’t comfortable building a portfolio hedge on their own by buying options, volatility, and shorting the market. For this reason our strategies don’t work for everyone. In addition, many investors like to diversify their money across more than one strategy in an effort to limit volatility in their portfolio. So we though it would be a good idea to do a small overview some of the alternatives we’ve found. If you know of any others, please let us know and we’ll add them to the list. Also, please note that we’re not recommending any of these funds. We just thought you should be aware of them. Hussman Funds Probably the most well known fund that offers hedging for an individual investor
Last week several of our core market health indicators strengthened a bit, but not enough to overcome the indicators that showed weakness. The net result was an overall weakening in market health. As a result, we’re raising more cash in our Core Long / Cash Hedge strategy. It is now 60% long and 40% in cash. Here’s more information on our Long / Cash hedging strategies. In the chart below the yellow lines represent raising cash and the green lines are adding exposure to the stock market.