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5 Hedges For A Bear Market

Summary Recent stock market movement has sharpened investor interest in the implications of a significant longer term move on their portfolios. Although a long term downtrend has not been confirmed, plans for hedging the market need to be in place now. Five instruments for hedging a bear market are compared. For almost seven months the S&P500 traded in an amazingly tight range between 2,040 and 2,134 (4.9%). Market watchers are relieved that it has broken out of this range and are alert to the possibility it is the beginning of the next leg up or down. The astute investor will want to prepare for this by having a calmly prepared plan to counteract the S turm und Drang 1 that accompanies such event. Even after the activity of last week the direction of the market is uncertain. In the event the direction will be down, this article reviews some widely available investments that are used to hedge a falling market: -1x inverse index funds -2x inverse index funds -3x inverse index funds Actively managed bear funds Index puts With the possible exception of the -3x funds all investments are assessed in the context of a six month time frame. The objective is to provide portfolio protection in a large market move, not short term speculation. The Question of Timing Determining what constitutes a real change in the market is somewhat of an art, as many investors discovered after oil’s recent false breakout. One indicator used by a number of respected professionals, such as Eric Parnell , is a sustained move below the 200 day moving average. But what constitutes “sustained?” Last October the S&P500 went below its 200 day average for five trading days, which turned out to be a false break. However, times when the 200 day average was broken for more than 10 trading days have been rare. It has occurred only twice in 20 years: March 2001 and June 2008. These signaled a market on the way to the biggest declines in this century. Investors who waited to hedge until the signal was confirmed were still able to benefit from further declines of 37% in 2001 and 49% in 2008. No single indicator is definitive, but the history of the 200 day moving average certainly makes it worth monitoring. The Hedges Bear Index ETFs (-1x): These funds try to obtain results that correspond to the inverse (-1x) of the daily performance of an index. They invest in derivatives and prices move close to the same degree as the underlying index but in the opposite direction. Investors can choose from a variety of broad or narrower indexes, as in these examples: ProShares Short S&P500 (NYSEARCA: SH ) ProShares Short Dow30 (NYSEARCA: DOG ) ProShares Short MSCI EAFE (NYSEARCA: EFZ ) ProShares Short Financials (NYSEARCA: SEF ) Ultrashort Bear Index ETFs (-2x): These funds try to obtain results that correspond to double the inverse (-2x) of the daily performance of an index. There are again many to choose from, such as: ProShares UltraShort S&P500 (NYSEARCA: SDS ) ProShares UltraShort Dow30 (NYSEARCA: DXD ) ProShares UltraShort MSCI Emerging Mkts (NYSEARCA: EEV ) ProShares UltraShort Financials (NYSEARCA: SKF ) 3x Bear ETFs: These funds try to obtain results that correspond to triple the inverse (-3x) of the daily performance of an index. Following the examples above there are: ProShares UltraPro Short S&P500 (NYSEARCA: SPXU ) ProShares UltraPro Short Dow30 (NYSEARCA: SDOW ) ProShares UltraPro Short Financials (NYSEARCA: FINZ ) According to etfdb.com there are 76 bear ETFs available from a variety of companies. There are many indexes to choose from, such as homebuilders (NYSEARCA: HBZ ), banking (NYSEARCA: KRS ), telecom (NYSEARCA: TLL ), China (NYSEARCA: FXP ), and Mexico (NYSEARCA: SMK ). Time has a negative effect on all bear funds because of the nature of their investments and their requirement to rebalance daily (in most cases). This can be severe for the more leveraged funds, as shown by the following chart of SH (-1x), SDS (-2x), and SPXU (-3x) in the flat market from February 10 through August 10. Six month comparison of SH, SDS, SPXU: Because of the time decay and the leverage, most advisors (including Proshares itself), recommend the 2x and 3x funds for short term holdings only. Longer term, if the market direction doesn’t cooperate losses can be large. In the past two rising market years (through 8/19/15) as the S&P500 gained 26% losses for SH, SDS, and SPXU were 26%, 46%, and 62% respectively. However, as short term defensive instruments, these funds are superb. Over the past 5 days, SH, SDS, and SPXU have gained 5.29%, 11.54%, and 16.33% against the S&P500 loss of -5.24%. Five day comparison of SH, SDS, SPXU: Actively managed bear funds: These funds invest in puts and short sales of individual stocks they believe will underperform the rest of the market. The largest is the AdvisorShares Ranger Equity Bear ETF (NYSEARCA: HDGE ). According to its website, the stated objective is ” capital appreciation through short sales of domestically traded equity securities. The Portfolio Manager implements a bottom-up, fundamental, research driven security selection process. In selecting short positions, the Fund seeks to identify securities with low earnings quality or aggressive accounting which may be intended on the part of company management to mask operational deterioration and bolster the reported earnings per share over a short time period. In addition, the Portfolio Manager seeks to identify earnings driven events that may act as a catalyst to the price decline of a security, such as downwards earnings revisions or reduced forward guidance .” HDGE has been in business since 2011 — a difficult period for bears. In the flat six month market up to August 19 it had a decent performance of +1.84% vs. -1.54% for the S&P500. In the last 5 days it is up +4.88% vs. -5.24% for the S&P500. Overall it has performed close to a rate of 1x the inverse of the broader market. S&P500 Put Options: The topic of options is so vast that the discussion in a short article like this must be very limited. We will focus on purchasing six month at-the-money S&P500 put options as a hedge against the decline of the broader index represented by the SPDR S&P 500 ETF (NYSEARCA: SPY ). The great advantage of options is that they allow the buyer to control a large number of shares for a small investment. Using the six month at-the-money 198 put as an example, the cost as of August 23 is 11.91. Options are sold in lots of 100. For $1191 the buyer controls $19800 of SPY, equivalent to16x leverage. The tradeoff for this is that options expire after a fixed period and the price includes a time premium. To book a gain on this option SPY has to decline in an amount greater than the time premium, which is 6% (11.91/198). In six months, SPY will have to be close to 186 (198-11.91) just to break even as the time premium disappears. Excluding the brief drop last October, the last time SPY was at this level was April 2014. Large drops in the index before expiration will result in big gains. On Friday, August 21 alone, the six month at-the-money 204 option rose 2.18, or 19%. Comparison and Recommendations The chart below summarizes the performance of the instruments discussed in the flat market of year-to-date ending August 19 and the sharp move of August 20-21. The SPY put YTD loss is based on a six month put expiring at the money. Investment objective YTD to 8/19 8/20-8/21 SPY ATM put S&P500 6 mo. put -100.0% 32.8% est. HDGE active managed bear -3.5% 4.6% SH 1x short index bear -3.6% 4.9% SDS 2x short index bear -7.1% 10.1% SPXU 3x short index bear -11.6% 15.0% S&P500 reference 1.0% -5.20% To have true portfolio protection a significant portion of a portfolio must be covered. The unleveraged short ETFs discussed here only protect an amount equal to what’s invested. So, for example, putting $10,000 in HDGE or SH protects $10,000 of a portfolio. If one’s portfolio is much larger, say $100,000, $10,000 in hedges leaves 90% unprotected. SPY puts are more complex. The buyer can control a large number of shares, but they expire at a specific date and part of the cost may be a time premium. As the chart shows, they can provide big short term gains; over the longer term they are designed to move in an inverse one to one ratio with the underlying S&P500 minus the time decay. The 2x and 3x leveraged instruments are an efficient way to insure a significant amount of the portfolio without a time premium or expiration. 50% of a $100,000 portfolio can be fully hedged (insured) by $25,000 of -2x SDS and only $16,666 of -3x SPXU. Based on the above chart, in a flat market similar to the past eight months this insurance with SDS would cost you $1,775(-7.1% of $25,000). The same insurance with SPXU would cost $2,900 (-11.6% of $25,000). This insurance cost would quickly be covered by a 3.8% decline in the S&P500 (-3.8% x -2x SDS = +7.6%; -3.8% x -3x SPXU = +11.4%) Any discussion of leveraged inverse funds such as SDS and SPXU (as well as their bull counterparts SSO and UPRO) must acknowledge their significant risk. Market moves in the wrong direction are very damaging, and they will lose value in a flat market or in times of high volatility. In the recent six month flat market SDS lost 8% and SPXU lost 13%. On the other hand, after the recent market drop both SDS and SPXU are up 3% year to date. Readers can get a better understanding of the risks by studying how these funds performed under various market conditions in the past. The best hedge for a down market depends on each individual’s risk tolerance and time horizon. However, an important consideration is having enough of the portfolio protected. The unleveraged hedges discussed here (actively managed bear funds and 1x inverse index funds) require a large dollar for dollar investment for protection. If an investor can accept the risk, leveraged 2x inverse index fund and 3x inverse fund can insure more of a portfolio for less money. Index put options are another low cost choice with their own unique characteristics. 1 Sturm und Drang: “… literally “Storm and Drive”, “Storm and Urge”, though conventionally translated as “Storm and Stress”) is a proto-Romantic movement in German literature and music taking place from the late 1760s to the early 1780s, in which individual subjectivity and, in particular, extremes of emotion were given free expression …” — Wikipedia. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SDS over the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Do Not Blame China For Your Missed Opportunity To Reduce Risk

I did not predict the epic fall from grace for the S&P 500 SPDR Trust (SPY). There’s a whole lot more to the extreme selling pressure than drama on the Chinese mainland. The reality is that the financial markets had been telegraphing distress in dozens of meaningful ways for months. I’m not likely to add significant risk anytime soon, short of the Fed giving us another Bullard-like moment where rate hikes are off the table and QE is back on the table. In large part, I will take cues from key credit spreads and price ratios like the iShares 7-10 Year Treasury (IEF): iShares iBoxx High Yield Bond (HYG). Some are crediting me with calling the 6-day mini-crash. On the contrary. When I wrote “ 15 Warning Signs Of A Market Top ” on August 18, the intent was to discuss micro-economic (corporate), macro-economic, fundamental and technical reasons for reducing one’s overall allocation to riskier assets. I did not predict the epic fall from grace for the S&P 500 SPDR Trust (NYSEARCA: SPY ). Based on a Relative Strength Index (RSI) level below 17 – based on the fact that we are approaching lows not seen since October’s “ Bullard Bounce ,” one should anticipate a jump higher. Equally compelling? Since the bull market’s inception (3/9/2009), the S&P 500 has only closed in its 3-standard-deviation range (0.13% chance of occurrence) twice. It happened at the tail end of the eurozone sell-off on 10/3/2011; it happened again today, on 8/25/2015. Yes, you’re going to see higher prices in the immediate term. Relief rallies happen. On the flip side, it’d be foolish to think that a jump off of the floor will be enough to restore the bull market uptrend. Institutions, private clients and hedge funds will need to shift from net sellers to net buyers; they were net sellers in July and August . The pattern of decreasing revenues and decreasing dividends at corporations will need to show marked improvement. Credit spreads need to stop widening and perhaps begin to narrow, demonstrating greater confidence in borrower creditworthiness. And speaking of borrowing, the Federal Reserve will need to come up with a way to inspire as it raises overnight lending rates. A plan for a one-n-done hike across a six-month span? Perhaps an offer to move at a snail’s pace of just one eighth of a point every other meeting? The media may choose to pin all of the blame on China’s stock market collapse. Indeed, interest rate cuts, trading halts, short-selling bans, currency devaluation, looser lending rules and share-buyer incentives have done little to stop the exodus. Keep in mind, though, Chinese equities via db-X Trackers Harvest CSI-300 A Shares (NYSEARCA: ASHR ) crashed in June and July. The S&P 500 was within 1%-2% of its all-time high less than a week-and-a half ago. It follows that there’s a whole lot more to the extreme selling pressure than drama on the Chinese mainland. The reality is that the financial markets had been telegraphing distress in dozens of meaningful ways for months. The Dow Transportations Average had been sickly since the first quarter earnings season, suggesting that manufacturers were not delivering as many goods for worthwhile profits. By early June, broad-based energy corporations in the Energy Select Sector SPDR ETF (NYSEARCA: XLE ) had climbed off of March lows, but they were still mired in a sector-specific bear that began in late 2014. Equally disturbing, at one point in June, the price-to-book (P/B), price-to-sales (P/S) and price-to-earnings ratios (P/E) for the “median” stock on U.S. exchanges had never been higher. Not even during the delusional dot-com days of 2000. As investors were entering July, troublesome deterioration began occurring in market breadth. The Bullish Percent Index (NYSE: BPI ) for the S&P 500 still showed a bullish reading above 50% (59%), yet less and less S&P 500 components had been forging uptrends. Prominent sectors like the Industrial Select Sector SPDR ETF (NYSEARCA: XLI ) began pushing 8% corrective levels on weak wages and weak manufacturing data. Later in July, foreign developed stocks were dropping precipitously and diverging from the U.S. market, highlighting the fading enthusiasm for euro-zone quantitative easing (QE). And high yield bond distress was a clear indication of credit risk aversion . The point here is, we hadn’t even gotten to August, and the signs of a probable sell-off in U.S. equities had been everywhere. You want to blame the second leg down of the stock market bear in China for everything? Why ignore the first leg? Why dismiss free-falling commodities in the summertime, from oil to copper to base metals? Why act as though the consecutive quarters of decreasing sales and lackluster profitability at U.S. corporations hasn’t mattered? Or the anxiety about Congress and the White House with respect to upcoming budget negotiations? Or the most obvious issue of all – angst over the Fed’s explicit goal of hiking rates as early as September. It follows that I have been discussing a tactical asset allocation shift for several months in my columns. I offered simple solutions, such as a moderate growth investor with 65% growth (e.g., large, small, foreign, etc.)/35% income (e.g., investment grade, high yield, intermediate, long, etc.) shifting to 50% growth (primarily large cap)/25% income (primarily investment grade), 25% cash/cash equivalents. A number of anonymous commenters at sites where financial portals regularly republish my articles demonstrated a remarkable penchant for viciousness. They attacked out-of-context word choices. They slammed the evils of rebalancing through tactical asset allocation as market timing idiocy. Some merely raged against my so-called negativity. Ironically, few could debate the array of well-researched and well-presented data – fundamental, technical, micro-economic (corporate) and macro-economic information that served as the basis for my recommendation to “sell a few things high” and hold some cash to limit downside loss and prepare for a future “buy lower” opportunity. And therein lies a problem for the complacent among us. The definition of opportunity is relegated to the “buy side.” Why should that be? When there are 30 some-odd reasons for reducing risk compared with a handful of reasons to stand like a possum in the headlights (I gave 15 in the Market Top feature from one week ago ), shouldn’t we embrace opportunities to lock in profits and/or protect our principal? I appreciate the kudos from those who have written – personally or on message boards – to thank me for “getting them out” in the nick of time. But I don’t have a crystal ball. And I did not suggest leaving risk assets altogether. I simply made the case for why the time for target risk allocations or greater-than-normal stock exposure had exited months ago. I’m not likely to add significant risk anytime soon, short of the Fed giving us another Bullard-like moment where rate hikes are off the table and QE is back on the table. I may even sell a bit more into the oversold conditions that are likely to bring about relief rallies. In large part, I will take cues from key credit spreads and price ratios like the iShares 7-10 Year Treasury (NYSEARCA: IEF ): iShares iBoxx High Yield Bond (NYSEARCA: HYG ). If the IEF:HYG price ratio is declining, a preference for risk-taking would be increasingly evident. That’s clearly not the case today. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at th e ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

How To Invest As Fear Is Thrown Into The Market

Summary As fear increases in the market, volatility has rapidly risen in one of the shortest timeframes on record. Traders betting on a normalization of expectations should position for an eventual decline in volatility. Investing alongside the impact of contango results in the best returns. Investments never consistently trade in a single direction forever. Over the past week, the crash of major stock indices has been a stark reminder that surprises to investors can happen very quickly and that fear itself can often prove to be a powerful force to be reckoned with. Yet potential opportunities exist in every situation. One such trade to now consider is the eventual suppression of uncertainty as the stock market once again normalizes and regains its composure. Over the last few days, volatility has very rapidly been increasing as a result of this uncertainty. This can be seen in the graph of the Volatility S&P 500 Index (VIX) found below as compared against the S&P 500 represented by the SPDR S&P 500 Trust ETF ( SPY ) . The VIX is quoted in percentage points and roughly equates to the expected movement in the S&P 500 index over the subsequent 30-day period when annualized. The index is a largely constructed by utilizing the implied volatilities of a wide range of S&P 500 index options. In general, the VIX represents the expected swing of the market in either direction as an expressed percentage over a given period of time. Since trading at a low of $13 on Monday, August 17, the Volatility S&P 500 Index soared to a closing price of $28 on August 21. This is greater than a 100% rise over the course of days, and therefore represents one of the most sudden movements recorded in the index’s history. It also reflects the high degree of uncertainty in the market as investors scrambled to buy options in order to gain protection for their investments. Yet as it often tends to be the case, fear and uncertainty naturally subside over a given course of time. Historically, this too can often unfold in a very rapid manner. As noted in the graph below, the VIX frequently spikes only to rapidly return back to a more sustained level in the mid-teen price range. Reasonably, this allows for a trader to predict and to invest into the normalization of market uncertainty by positioning for the eventual decline in the VIX. While investors can directly invest into the VIX through the utilization of call and put options, those unfamiliar with the use of these trading tools can still capitalize upon this predictable trend. One such investment method is to consider a short position in a related fund that is correlated to the VIX. For example, the iPath S&P 500 VIX Short-Term Futures ETN ( VXX ) is an exchange traded note that offers exposure to the daily rolling long position in the first and second month VIX futures contract. Yet as a consequence of contango, the VXX is almost inherently designed to decline in value. Contango occurs due to the perishable value of the premium attached to futures prices set before the expected delivery date. As a consequence of contango and the reliable trading action of the VIX itself, the long-term trend of the VXX is made abundantly clear in the graph shown below. Over the long-term, contango and the lack of a consistently fearful market typically dictate the downward trend of the investment. As seen in the graph below, such a trend has been well defined for many years. (click to enlarge) However, not everyone is capable of entering into a short position. There is also an inherent danger as the potential losses of a trend that backlashes against expectations are theoretically limitless. Therefore, investors could alternatively go long a VIX inverse investment such as the VelocityShares Daily Inverse VIX Short-Term ETN ( XIV ) in order to capture a similar trend. This investment seeks the inverse performance of the S&P 500 VIX Short-Term Futures Index. For those wanting to limit the volatile nature of the this long position, one can also consider the VelocityShares Daily Inverse VIX Medium-Term ETN ( ZIV ) . This investment seeks the inverse performance of the S&P 500 VIX Mid-Term Futures index. The difference between these two futures indices is that the short-term index utilizes the prices of the next two near-term futures contracts whereas the mid-term index utilizes the prices of the fourth, fifth, sixth, and seventh month future contracts. As a result of this, the mid-term index faces significantly less volatility and a reduced impact from contango. The resulting trends of each of these investments can be found in the comparison graph below. While both XIV and ZIV have historically trended higher, it is clear that traders seeking higher returns are more prone to invest into XIV following a deterioration of the upward trend, which occurs when increased fear returns to the market. Final Thoughts It is important to remember no one is capable of predicting the future with perfect accuracy. As such, both traders and investors should often consider utilizing multiple entry points in order to average down into a comfortable position. Just because fear and volatility have risen to a very high point in a limited amount of time, there is no reason to believe that it will not be able to continue to rise in the days and potential weeks to follow. Nevertheless, for the patient investor capable of identifying opportunity when it passes by, the potential return from a predictable trend found in volatility can often be quite rewarding. After all, the odds of a market that continues to consistently become ever more fearful is rather slim statistically. Disclosure: I am/we are long XIV, ZIV. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.