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Using Options to Hedge Market Risk

Another crazy week in the market.  Investors vacillated from panic to manic and back to panic.  The net change for the week was not so significant, but the fluctuations were huge.  How can you cope with a market like this?

You might consider using options to hedge against market moves in both directions.  Check out how two of our portfolios are doing it.

Using Options to Hedge Market Risk   

Some Terry’s Tips subscribers choose to mirror in their own accounts one or more of our actual portfolios (or have trades executed automatically for them by their broker).  We recommend to that they select two portfolios, one of which does best in an up market and one that does best in a down market.

Almost all of our portfolios do best if not much of anything happens in the market, but that has not been the case in the last few weeks.  It is during times like this that both a bullish and bearish portfolio be carried out at the same time.

We have one bearish portfolio.  It is called the 10K Bear.  It is currently worth about $5000 (although we have withdrawn $2000 from it to keep it at the $5000 level for new subscribers – it had gone up in value by 54% over the last couple of months while the market was weak).

Here is the risk profile graph for the 10K Bear portfolio.  It shows how much the $5000 portfolio should gain or lose by the regular September options expiration this Friday at the various possible ending prices for SPY (currently trading just under $116): 

Using Options to Hedge Market Risk

  

Some Terry’s Tips subscribers choose to mirror in their own accounts one or more of our actual portfolios (or have trades executed automatically for them by their broker).  We recommend to that they select two portfolios, one of which does best in an up market and one that does best in a down market.

Almost all of our portfolios do best if not much of anything happens in the market, but that has not been the case in the last few weeks.  It is during times like this that both a bullish and bearish portfolio be carried out at the same time.

We have one bearish portfolio.  It is called the 10K Bear.  It is currently worth about $5000 (although we have withdrawn $2000 from it to keep it at the $5000 level for new subscribers – it had gone up in value by 54% over the last couple of months while the market was weak).

Here is the risk profile graph for the 10K Bear portfolio.  It shows how much the $5000 portfolio should gain or lose by the regular September options expiration this Friday at the various possible ending prices for SPY (currently trading just under $116):



Remember, this is an actual brokerage account at thinkorswim which any paying Terry’s Tips subscriber can duplicate if he or she wishes.  The graph shows that if the stock stays absolutely flat next week, there could be a gain of over $1000 for the week.  If the stock should fall by $2, an even higher gain should result.  (Once the stock falls by $2, we would likely make some downside adjustments so that further drops in the stock price would generate higher gains.  After all, this is our bearish bet.)

Where else could you expect a 20% gain if the market doesn’t move one bit?  In a single week?  Or even more if the market should fall?

Admittedly, today’s option prices are extremely high (in 92% of the weeks over the last 5 years, option prices have been lower than they are right now, so we are in truly unusual times).  The risk profile graphs for our portfolios usually do not look as promising as they do right now.

One of the bullish portfolios that we recommend to be matched against the 10K Bear portfolio is called the Ultra Vixen.  This portfolio is based on the underlying “stock” (actually an ETN, an exchange traded note) called VXX.  This index is based on the short-term futures of VIX (the measure of SPY option prices, the so-called “fear index”).  When the market drops, VIX generally rises (as do the VIX futures prices), and VXX usually moves higher.  Over the last month while the market dropped over 10%, VXX has more than doubled in price.  For that reason, many people consider VXX to be an excellent hedge against market crashes.

We don’t like VXX as an investment possibility, however.  Over time, due to a mechanism called contango (futures prices become more expensive in further-out months), VXX is destined to fall over time.  It may be a good hedge as a short-term investment but is awful as a long-term holding.  It fell for 12 consecutive months last year, for example, even though VIX fluctuated in both directions.

Our Ultra Vixen portfolio is set up to benefit when VXX goes down (which it does when the market is flat or goes up).  We generally maintain a net short position on VXX with some call positions for protection in case the stock does go up.  However, our portfolio does best if the market stays flat or moves higher, so it is a good hedge against the 10K Bear portfolio.

Here is the risk profile graph for Ultra Vixen for next Friday’s expiration (September 16th).  It is a $10,000 portfolio and the underlying stock (VXX) is trading about $45.83:





The graph shows that a 10% gain for the week is possible if the stock falls as much as $3 or goes up by as much as $2.  (Historically, in about half the weeks, VXX fluctuates by less than a dollar in either direction.)  Where else besides options do you find opportunities like this?  In a single week?

Both the 10K Bear and Ultra Vixen portfolios should make excellent gains every week when the market is flat, and one or the other should make gains when the market moves more than moderately in either direction.  Theoretically, if the two portfolios together break even in the high-fluctuation weeks and they both make gains when the market doesn’t do much of anything, the long-run combined results should be extraordinary.

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