Slope of Hope Blog Posts

Slope initially began as a blog, so this is where most of the website’s content resides. Here we have tens of thousands of posts dating back over a decade. These are listed in reverse chronological order. Click on any category icon below to see posts tagged with that particular subject, or click on a word in the category cloud on the right side of the screen for more specific choices.

Hedging the Dow

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Hey fellow Slopers,

In our last post on hedging, we looked at hedging Internet stocks and ETFs. In this post, we'll look at hedging the Dow (via the SPDR Dow Jones Industrial Average ETF SPY) and its components. But first, it's worth asking why an investor might consider hedging now. Two reasons come to mind:

1) Hedging has gotten cheaper recently, as volatility has declined. As of March 28th, the VIX was back below 20, after spiking up to around 30 earlier this month, a few trading days after the 2011 Tōhoku earthquake and tsunami hit Japan.

 

2) Prudence may be warranted with the end of QE2 scheduled for the end of June. On Bloomberg TV Monday, David Rosenberg, chief economist at Gluskin Sheff & Associates (formerly chief North American economist at Merrill Lynch noted the correlation between the Fed's quantitative easing and the direction of U.S. stocks during the current cyclical bull market off of the March '09 lows: 

It’s one thing to have a fundamentally-based bull market: they tend to last for many, many years. But liquidity: it’s there one minute and can be gone the next minute […] In the past two years there’s been an 88% correlation between the movements in the Fed balance sheet and the direction of the S&P 500. If the Fed embarks on some exit strategy in the second half of the year, much like they did for a temporary period last year, it will be interesting to see how the market responds once QE2 runs its course if QE3 doesn’t follow suite in June or July

Rosenberg went on to say that he thought there would be a QE3, but that it might not come until this time next year.

With that in mind, below is a table showing the current costs of hedging each Dow component, and the Dow-tracking ETF DIA, against greater-than-20% declines over the next several months using the optimal puts (I used the Portfolio Armor iPhone app to pull up the optimal puts for these securities, but you can also use the web app versions of Portfolio Armor). First though, a reminder of what "optimal" means in this context, and a note about the time frames involved. The optimal put options are the ones that will give an investor the level of protection he wants at the lowest possible cost. Portfolio Armor uses a proprietary algorithm developed by an all-but-dissertation finance Ph.D. candidate to find the optimal contracts to hedge stocks and ETFs.

In his research, the Ph.D. candidate who developed the algorithm found that options with approximately 6 months to expiration tend to offer the best combination of liquidity and cost, so those are the puts for which Portfolio Armor's algorithm aims. When puts with about six months to expiration aren't available, Portfolio Armor searches for slightly longer or shorter times to expiration. In the table below, unless marked with an asterisk, the optimal put option contracts for the security expire in September; one asterisk indicates the options expire in August; two asterisks indicate that the options expire in October. All things equal, one would expect options with less time to expiration to be less expensive, and ones with more time to expiration to be more expensive.

Disclosure: I have a limit order in to buy the optimal puts on DIA referred to above.

Retracement Targets (by Springheel Jack)

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Obviously I was right to think that the setup looked weak yesterday and the short term support trendlines for ES and NQ were broken at the close. For those of you following me on twitter I posted the short term patterns yesterday afternoon with an observation that we were likely to see a break down from them. For any of you wanting to see intraday updates from me my twitter handle is shjack666.

I've had a late start this morning so I'll keep it short today and just focus on ES, NQ and copper (HG). On ES the short term triangle / falling wedge broke down and a very nice looking declining channel has formed. As long as that channel lasts, playing this retracement will be very straightforward, so I'm hoping that it lasts until this retracement reaches my main targets today or tomorrow:

In terms of the main target for this retracement, I'm thinking that the larger rising wedge that also broke down yesterday, and retested overnight, may turn into a rising channel. If so then the target today would be in the 1286-90 area:

In terms of this just being a retracement, both the pattern setup and the target are clearer on NQ. On the 15min chart NQ broke down from the short term gentle declining channel yesterday and has formed a small falling wedge. Again, as long as that lasts the upside and downside trendlines are easy to play:

In terms of the bigger picture on NQ, the obvious retracement target is the 2270-5 area for the lower trendline of the rising channel as I mentioned yesterday. If that lower trendline is broken I'm going to start wondering about a lower low, as there is a larger declining channel in play until declining resistance from the recent top is broken:

EURUSD has held support, but copper broke support yesterday and I've been considering downside targets there. No single target springs to the eye, but there is a potential neckline at 427, strong support at 425, and if 425 is broken, then there is a declining channel pointing to a test of 400. Short term copper is trying to bottom looking at the 60min RSI, and we might see a bounce to reset that before it falls further:

I'm expecting more downside and will be expecting more downside until ES and NQ negate the current setup by breaking up through declining resistance from the recent top, or my targets are hit. Longs should be cautious today and if my downside targets are exceeded, then there is a strong possibility that we will see lower lows on equities.