Hedging a Portfolio with Options: Part 1

What's Hedging?

Hedging is an investment strategy intended to offset potential losses. So, when the market goes down, we're going to buy a protective put, to hedge our position.  If the market goes down the put will increase in value and counterbalance the loss you could have in the stock portfolio. When you think it's going to turn back up, and once again we're going to be using the exponential moving averages, you sell the put to get out of the hedge. Any profits that we made from that, we're going to buy additional shares. That way we're going to compound our shares with the money we made during a correction. This is going to be a two-part lesson.

Part 1 | Overview

The first part, I will discuss the two indicators I use and how to set up your charts on Think or Swim. The first one is the 8 and 21 day exponential moving average line, and the next one is, the Fibonacci extensions. The EMA lines are what I use to get in and get out of a trade. The Fibonacci's are what I use to see if a correction is overextended. Then we're going to go over the hedging rules and talk about downside corrections. Downside correction is usually a slow roll over.

It takes a while for the market to slow down and then drop. It usually takes on the average of about four weeks, so, we've got plenty of time to recognize when a potential drawdown might happen to go ahead and put our hedge on.  The hedge timing is not that critical because of that slow roll over, and I'm going to show you a couple examples where we put on a hedge 12 days apart, seven days apart and it didn't make much difference as far as the protection we had on our portfolio and the profits that were made.

Part 2 | Overview

The second part of this lesson we're going to talk about, which Put Options are we going to use and how far from expiration are we going to buy. Will we use in the money, at the money, out of the money put options? We're going to talk about which ETFs we want to use to hedge.  Then I'm going to go through the process, and we're going to take 2016 as an example, and I'm going to take you step by step, what I saw, what I did as far as buying Puts, when we got in, when we got out and whether it was profitable.

Hedging Your Portfolio with Options | Part 1

First let's look at the two indicators, the exponential moving average line and the Fibonacci ratios. Then we will discuss the hedging rules, the downside correction, the slow roll over and that hedge. The timing is not that critical as far as our hedging is concerned. We are going to buy protective Puts when we see that a potential correction is due in the market.

Hedging with Options |  Real Trading Example

This is just an example, on December 16th, the SPY was at 205.  Let’s say you had a hundred thousand dollar portfolio. You can take any number that you have with your portfolio, and put it in here, and recalculate these to see what you would have done. But we're going to use a hundred thousand dollars just to make the calculations easy. Divide the one hundred thousand dollars by 205, which equals 488 shares (If we had the portfolio all in SPY).

So, at that point in time what we want to do, is, we want to buy five, February 205 Puts. Five, because we had 488 shares we want to protect. Now, each contract of options is worth a hundred shares. So, all we have to do is, buy five puts and that will protect us if it drops.  Now on December 16th the SPY Put option was valued at six dollars and 38 cents. Five times that is three thousand one hundred ninety dollars, which is about 3.2 percent of your portfolio that you're going to use to buy insurance.

What happened is that the market did fall. On January 20th, we sold these Puts that we bought at six dollars and 38 cents for nineteen dollars and 42 cents. We made six thousand five hundred and twenty dollars profit on the Puts. The SPY had dropped from 205 to 185, I took the six thousand five hundred twenty dollars and bought 35 more shares.

We originally started out with 488 shares, we bought 35 additional shares, and we now have 523 shares at 185. We’ve now got more shares and the portfolio size is about the same as it would have been, when we put the hedge on.

We had the protection, plus we bought additional shares at the bottom when it reversed back. Now, we've got a bigger portfolio when the market advances. That’s hedging in a nutshell.

Hedging with Options |  Real Trading Example 2

(video transcript)

Let's take a look in 2016. There were four times we hedged. The first time was the 13th of December in 2015, and you can see this was a pretty big drop.  We got out of the hedge at this point. There was another hedge we put on here, and then it also had a pretty big drop.  This was our third hedge in 2016 that happened around June, and the last one was in September. Okay, how did we see these? Enter the eight and 21-day exponential moving average line. The Green Line is the eighth day, and the Gold Line is the 21 day. And as you'll see with the rules when we talk about these later on, when the SPY which is what I use for the market indicator drops below the eight day EMA, that's the time to place a hedge. You don't have to rush in right away, it's not as soon as it crosses, I like to see it close below there. Maybe watch it for a while and then I'll put the hedge on.

Hedging in the ThinkorSwim Platform

(video transcript)

Let's go over to our think or swim platform for a second. This is the SPY and you can see the 8 and the 21 day exponential moving average line. Let me just go ahead and take those off, and I'll put them back on for you and I'll show you what I'm going to do. Okay, so, to apply the 8 and 21 day exponential moving average line you go to Studies. Then Edit Studies. Scroll down on the left hand side, and look for moving average exponential. Double click that. Then do it again because we want to do the 8 day and the 21 day. Come up here to this little gear on the far left hand side, click on it. Change the length to eight days. Go with the width of one or two and make it green. Come down here and say okay.

Then come down to the second one we put on there. Click on the gear, change this to twenty one days. Come down and make this width three, and the color gold. Go ahead and say okay, apply, okay. So, you've got the eight day and the 21 day exponential moving average line put right on your chart - it's that simple. If the SPY drops below the 8 d EMA we place the hedge. And then as long as it stays below the twenty one day I want to keep the hedge on. Soon as it crosses over the 8 d EMA we want to get back in, or if we see that the Fibonacci's dropped to a level that it makes sense for us to get back in.

Measured Moves & Fibonacci Extensions

Let's talk about the Fibonacci's for a second, well first of all this is an area that we hedged in and this was this year 2017. And, I want to show you how we use the Fibonacci's to kind of jump ahead of the market.

You can see that this was the high right here, and it came down to a low, it passed through the eight day exponential moving average line, it's time to think about putting on a hedge. Then it made a lower low right here, this is what's called a measured move.

Once you have a measured move, you can put on a Fibonacci extension, which you're going to automatically apply on your Think or Swim chart. If you don't have Think or Swim, all you have to do is contact your trading platform and say how do I apply the Fibonacci's?  So, you see this example here, you can see that it dropped down to the 161%, which is a level where it's either going to blow right through there and continue on down, or we're going to have a correction or consolidation back up.

At this point we had a correction and it actually turned back up. This would have been a great point to get in after taking the hedge off.  Let’s talk more about measured moves. The classic definition of an uptrend is higher highs and higher lows. The definition of a downtrend is lower lows, and lower highs. This is a bullish major move. Let's say, we're going up, it makes a high, then it retraces back and makes a higher low. Then it continues back up and at this point makes a higher high. That is a completed measure move to the upside, that confirms we have an uptrend and at this point in time, you can put on Fibonacci's and get a pretty good idea of where you can expect it to go, before it runs out of steam.

The bearish major move it's just the opposite. We've got a high, that drops down, then it retraces to a lower high, and then it crosses down and makes a lower low, this is a bearish measured move. Once you have those major moves you can apply for Fibonacci extensions to them.

Fibonacci Ratios and Trading

Fibonacci ratios are seen throughout nature. As you go up the stem of a flower, the leaves grow at proportion to the distance of the ratio. The spirals of a sea shower proportion to the ratio. The distance of the human forearm to the hand is proportional to the ratio, and so, are all the major bones.

Mine is seven and a half inches, my hand is seven half inches. The distance from my elbow to my wrist is 12.3 inches. If I divide 7.5 by 12.3, I get .61 and that is the Fibonacci ratio. It is seen throughout nature.

Doesn't it make perfect sense that the markets, would be in perfect harmony with nature. What fuels the markets other than human fear and greed? And that's where the Fibonacci's come into play to tell us when a move might be overextended, and maybe it's time to take the hedge off. Now let's talk a little bit more about the Fibonacci's.

Fibonacci the Man

Fibonacci was a mathematician, and he came up with a number sequence that was derived from adding the current number, to the previous number, to get the next number in the sequence. In other words, one plus one, equals two. One plus two equals three. Two plus three equals five. And so, forth. You'll notice that in here we have eight and twenty-one. That's why I use the eight and 21-day exponential moving average line.

The Fibonacci Ribbon

That's what I call the Fibonacci ribbon. Now, what he did, is he took any number and divided it into the preceding number, and came up with 0.618 and that's called the root Fibonacci ratio. Then later on mathematicians took the square root of that, and the square of that. And then took the reciprocal of that, and those are what I use for extensions.

Applying Fibonacci Extensions in ThinkorSwim

The 127%, the 161% and the 261% extensions, they are automatically put on the chart, in Think or Swim. Let me show you that. Come down here to the tools, and click on the tool for Fibonacci extensions. If you start from the low and go to the high here, then click and go to the higher low and click it will automatically put in the 127%, 161% and 261%.  These extensions gives you an idea of where this move might go before it runs out of steam. You can see it came through the 127%, pulled back just a little bit, continued on, came up to the 161%, and in between the 161% and the 261% is where it finally halted.

These are tremendous tools to see where the market has been and where it might go. The tool that I use, are the 8 and the 21-day, exponential moving average line, and the Fibonacci extensions, I really rely on the 127% and the 161% as places where we might get a turn around, might be time to take the hedge off.

Hedging Rules & Setups

Let's take a look at this diagram on the hedging rules. First of all let's say that the price closes below the eight-day exponential moving average line. When it does that is the time we want to put on the hedge. Now, if it comes down here and the price goes below the 21 day we want to keep the hedge on. Next, we want to look for the price the close above the 8-day EMA, to take the hedge off. Or, if it gets through a Fibonacci extension we might do that. But let's say we have the hedge on, we're below the 21-day, we come over here, up to the top and now the eight day exponential moving average line crosses above the 21-day, and the price closes greater than the 21-day. That's the time to take it off.

We start all over again if it closes below the 8-day EMA and put the hedge on. Okay, so, long as it closes above, we're going to keep the hedge off. And let our portfolio run. But as soon as it goes below the eight day, we're going to hedge our hard-earned money in our portfolio and protect it.

So, long as it stays below the twenty one day, we're going to keep it on. As soon as it goes above that, we're going to take it off. I have the  hedging rules right in front of me, to protect your portfolio and know when to put on those protective Put Options.

Hedge Timing

Let’s talk about the timing of when to put the hedge on.  I went back in the last five years and it took an average of 4.5 weeks for the bull market to end, and for it to finally roll over. So, you've got some time to put your hedge on. I look at that and say okay I better pay attention now, because I think I've got some time, but if it starts dropping below the 8-day, I want to get out.  I want to hedge my portfolio.

Hedge Timing | 2014 Analysis

In 2014 there were four rollovers. And it usually averages about four to six in any given year, when you're going to want to put a hedge on. We looked at 2016 earlier, and that was four times also. Here's a drop that was one, two, three and four times we wanted the hedge our portfolio, but notice the time that we have to do that.

The first one here was a 12 day rollover. When it first crossed below the 8th day, that was on January 6th and here's what you would have bought - the February 182 Put, then sold it on February 4th. If you waited all the way out till January 22nd, you still would have had a nice profit on your Puts. It’s not real critical to jump right in there right away.

The second one was a three-day rollover. You can see it, it crossed over and then it started dropping. Okay and but from the beginning to the three days later, the profit was just about the same.  This one was a seven day rollover, so, you can see that getting in and getting out was about the same here.

Conclusion

We covered a lot here and I hope it was informative as I’ve taken years back testing and refining the rules and setups that get in and out of hedges seamlessly.  Take a minute to absorb and test your own findings before moving on to Part 2 of Hedging Your Portfolio with Options. There is also a ton of option trading video education that I’ve published right here at OI.  I also recommend looking at my 2 memberships that absolutely destroyed in 2017.  See you for Part 2!