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Rolling Your Hedges in Bull Markets


The markets have regular and often vicious corrections. Hedging during those periods will almost always yield enough alpha to make up for a decade of difficult investing decisions.

Fast-moving markets that are going up are not that great for the bullish buy-and-hedge investor. Don't get me wrong – you still make money. But when you are hedged in bullish positions, you would prefer steady upward-moving markets.

Being hedged is like having insurance – so it is not free. To help defray that cost, we often sell away our upside in the near months. We do that by deploying either the collar tactic or the spread tactic. When we use those tactics, we have effectively given up some of our upside in exchange for some premium to offset our downside.

When we sell away our downside, we usually try to sell it in the near month – when the time premium expires the fastest. Time premium that expires is good – when you have sold it. You hope it will expire worthless – but just barely worthless.

So far, in 2012, the bull is rearing his beautiful head. At my firm, we like up-markets. In general, we are long-term bullish investors. Our positions are making money. However, the last month was a sharp move up. So, some of our positions have some upside value that we have given up. In other words, in our collar tactics, our calls are in the money (or ITM). In the case of the spread trades, the upper bound strike price of the spread has been breached.

Look at a few of our favorite positions since the last expiration in January:

ETF Price +/- in %
SPDR S&P 500 (SPY) $134.86 +2.20%
SPDR MidCap Trust Series I (MDY) $176.85 +4.40%
SPDR Select Technology Sector Fund (XLK) $28.11 +5.00%
iShares MSCI Emerging Index Fund (EEM) $43.24 +4.50%
SPDR Select Energy Sector Fund (XLE) $73.65 +3.22%

More than likely, with expiration coming this Friday, you are OK on your (SPY) and (XLE) positions. However, back in January, the premiums you could collect to sell the upside in (MDY), (XLK), and (EEM) were not that high. So, you might have sold some upside at lower-than-usual strikes. Which means that you might have an ITM call set to expire in a collar hedge on one of these on Friday.

What do you do as the hedged investor? Do you look to roll now? Or roll on Friday? Take a deep breath and remind yourself that you have a few more days here. Unless you have a very strong feeling that something is going to happen in the market to the upside between now and Friday, I recommend you wait and see if the market might retrace itself. You are almost certainly only a little bit in the money on these positions – so it's probably worth waiting.

Remember, we don't try to time the market! Timing is a short-term strategy. We are playing for the long haul.

Hedging is best deployed as a long-term strategy. The longer the time period you look back on, the higher the probability of a sharp decline in the market. If you read our book, Buy and Hedge: The 5 Iron Rules for Investing Over the Long Term, you know that the markets have regular – and often vicious – corrections. Hedging in those time periods will almost always yield enough alpha to make up for a decade of difficult investing decisions. Remember that lesson!

Editor's Note: For more from Wayne Ferbert, go to Buy & Hedge ETF Strategies.
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No positions in stocks mentioned.
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