I have touched on the subject of hedging before, but one reader posted this question:

Can you please clarify what hedging means?

In one of the posts I read:

“The safest and most responsible way to use reverse-index ETFs is to hedge or protect your equity portfolio in a bear market.”Suppose I hold $ x worth of an ETF. How are the following two different from one another?

1. Buying $ x worth of inverse ETF? (This means, whether the market goes up or down, the value of my portfolio remains the same – am I right?)

2. Selling the $ x worth of the ETF and having it in money market.Are not 1 and 2 above the same in terms of value after so many months? (In the case of 1 above -Till the time I liquidate the long or inverse ETF are not 1 and 2 above same?).

In theory, you are correct. The value of a short position is supposed to make up the losses of a long position—if we’re going through a bearish period. This is 100% true if you have two accounts and in one you hold 100 shares of IBM, while in another account, you sold short 100 shares of IBM. The gains and losses will cancel each other out.

However, the story is different when you mix mutual funds and inverse ETFs where the relationship is not exactly definable. That discrepancy can lead to profit opportunities while limiting downside risk. I have done a lot of research in that area, but I can’t share all results yet, since my work is not finished.

However, I will give you two small opposing examples of how hedging could have produced profits. A few months ago, we’ve had 2 subsequent 3-week periods, one bullish and one bearish, during which I held 2 mutual fund positions, which were hedged with SDS.

First the bullish period:



Please note that during this period, the S&P; 500 gained sharply by rising +6.31%, while the hedged position went up by +3.50%. A month later, the bottom dropped out and during the subsequent bearish period, the numbers changed as follows:

The S&P; 500 lost -5.86%, while the hedged position gained +1.99%. On balance, the hedges produced a profit, while the S&P;’s gains and losses pretty much canceled each other out.

When I picked these periods during my research project, they were selected only because of the market’s sharp rise and fall and not because the hedge results turned out positive. I have looked at hundreds of examples and, while using a hedge like this will not always result in a profitable outcome, the downside risk was sharply reduced, while, at the same time, upside potential was limited.

However, when used over longer periods, including bear markets, the results have been quite impressive because of the reduction in volatility. So hedging will not necessarily put your portfolio in a 100% neutral position, it can also be used to produce profits no matter which way the markets trend.

I currently have no holdings in any of the funds/ETFs mentioned.

I just finished reading Charles Morris’s “Trillion Dollar Meltdown,” which describes the recent years of easy money, high rollers and the great credit crash.

According to Morris, an acclaimed financial writer, the sub-prime crisis is only a preview of the havoc that will play out across the full spectrum of financial assets. Arcane credit derivative bets are now well into the tens of trillions. The astronomical leverage at major banks and their hedge fund and private equity clients virtually guarantees massive disruption in global markets.

The book explains the arcane financial instruments, the chicanery, the policy misjudgments, the dogmas, and the delusions that created the greatest credit bubble in word history. Paul Volcker slew the inflation dragon in the early 80s, and set the stage for the high performance economy of the 1980s and 1990s. But Wall Street’s prosperity soon tilted into gross excess.

Now global confidence in American securities has been shattered, the dollar debased, and the crown jewels of American industry put on auction to foreigners. Continued denial and concealment could cause the crisis to stretch out for years, but financial and government leaders are still downplaying the problem.

This is where things can get ugly for your portfolio, if you don’t realize that a Black Swan event could be lurking around the corner. While you can’t do anything about the facts as Morris describes them in his book, you can take simple measures to protect your portfolio should the crisis accelerate. Have a disciplined entry and exit strategy and never ever work without the use of a sell stop.

The book is an easy read and will get you up to speed, in case you missed some of the developments leading up to the unwinding of the greatest credit bubble in history.

There are many different viewpoints on how to invest your money, whether it is during the accumulation phase of your investment life or after you “have arrived.”

To my way of thinking, the approach for growing your assets is entirely different from the one you should use if you find yourself suddenly with a windfall in the range of 10s of millions of dollars.

One of my clients faced such a situation after he sold a portion of his business and had moved, as I refer to it, into the Investment EndZone. What is it?

It’s a state of financial independence that allows you to comfortably live off your investment income and assets without ever having to go back to work or take financial gambles.

Of course, the brokerage industry would want you to keep playing the same old investment game, since that has proven to be most profitable—for them. Take a look at the latest addition to my website called “High Net Worth Strategy,” and download my free 6-page report, which explains my thinking and how my client Roger handled this situation.

You may not have reached that point, but I think it’s important for anybody to know how you can get shafted and/or misled by advice that is not in your best interest.

My latest No Load Fund/ETF Tracker has been posted at:

http://www.successful-investment.com/newsletter-archive.php

Another whip-saw week with the major indexes closing to the downside.

Our Trend Tracking Index (TTI) for domestic funds/ETFs remains below its trend line (red) by -0.86% thereby confirming the current bear market trend.



The international index now remains -7.47% below its own trend line, keeping us on the sidelines.

For more details, and the latest market commentary, as well as the updated No load Fund/ETF StatSheet, please see the above link.

In an appropriate sign of the times we’re in, the FDIC may have to “Borrow Money from the Treasury” according to the Wall Street Journal:

Federal Deposit Insurance Corp (FDIC) might have to borrow money from the Treasury Department to see it through an expected wave of bank failures, the Wall Street Journal reported.

The fact that the agency is considering the option again, after the collapse of just nine banks this year, illustrates the concern among Washington regulators about the weakness of the U.S. banking system in the wake of the credit crisis, the Journal said.

Yes, considering this option this early in the game after the failure of only 9 banks is a troubling development and a clear sign that worse is to come.

The immediate question that comes to my mind is what happens if the losses of the anticipated bank failures exceed the current $45.2 billion dollar fund reserves? Sure, the FDIC will dip into their Treasury credit line to cover expenses, but then what? Who will ultimately foot the bill if there is a shortage, and most likely there will be?

Of course, you guessed it: The deep pockets of the taxpayer will as always be a ready and available resource to bail out failed institutions.

Monday’s sharp drop of the major averages gave the bullish crowd a lot to think about and confirmed our bearish stance. Follow trough selling was contained yesterday as the chart (thanks to MarketWatch) shows, with most of the activity being directionless bouncing around the flat line.

Despite sharp rallies and subsequent market drops we are now just about back to where the S&P; 500 started the month. The underlying cause for this confusion is of course the price of oil but also the realization that the problems in financial stocks will be with us for a while longer. Rating agency Fitch put insurance giant AIG on credit watch, because they are concerned that more large write-offs are looming.

As I have repeatedly said, until all skeletons are out of the closet, we will not see any normalcy in terms of fluctuations return to the market place.

As of yesterday, our Trend Tracking Indexes (TTIs) have moved to the following positions with regards to their long-term trend lines:

Domestic TTI: -1.06%
International TTI: -8.64%

We continue to watch things from the sidelines and will stay there until a clear breakout to bullish territory has materialized.