Sell Stops For Hedges

Reader comments are an important component of my daily blog posts. They add valuable information to the topic discussed and many times lead to more posts on related issues.

Some readers prefer to comment anonymously, which I don’t have a problem with unless this privilege is abused. This happened a few days ago when one reader addressed an issue in a way that should have been emailed to me directly for clarification. Naturally, his comment did not get published; however, he brought up a valid point, which I want to address today.

The issue most discussed over the past couple of weeks was the use of sell stops for ETFs, mutual funds and bond funds. But how about hedges? How are sell stops applied there?

Let’s review again the purpose of the hedge:

It allows us to safely establish a position “prior” to our domestic TTI signaling a Buy.

After the markets made their lows the beginning of March 09, we were able to set up a hedge during March even though our domestic TTI did not signal a Buy until June 3, 2009.

Let’s see how this hedge actually played out over the past few months and where the sell stop should be placed. Take a look at this tracking matrix for this particular hedge, which was set up for a number of clients:



[Double click to enlarge]

As you can see, during this bullish run, the short position lost 28.14%, but the long positions gained more resulting in an unrealized gain of 6.72%. The 7% sell stop will be implemented on the result of the entire hedge and not on the performance of its components.

In other words, the high gain made on 9/16/09 was +6.75% and the 7% sell stop loss will be calculated off that high number.

While this hedge averaged about 1% per month, this certainly pales in comparison with the S&P;’s +30.89%. On the other hand, the S&P;’s numbers are more of a statistical measure than anything else, because most investors certainly did not get into the market with a meaningful portion of their portfolios back in March.

As the markets confirmed their bullish trend, I dropped many (not all) of the short components for clients’ accounts in order to become net long and add to the positions. That choice strictly depended on the risk profile of the individual client.

Remember, this hedge concept may not be for you, but there are many investors who have had either very bad buy-and-hold experiences and/or are retired and prefer less of a roller coaster way of investing their monies.

I have always maintained that the comfort level an investor has with an investment methodology is far more important than the investment itself.