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Traders that hedged, not happy, but better off

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Traders that hedged some portfolios are bye no means happy as the broader market averages have seen lower prices since Monday's open, but many are glad they bought some insurance. Many institutions hedged some positions on Monday and often times it's the S&P 500 options market that they turn to. Let's take a look at the S&P 500 Index (SPX.X) and try to identify what institutions and investors will be looking to do as it relates to managing a hedge position. It's easy to put on a hedge, but managing it is also important.

S&P 500 Index Chart - last ten months

With the breaking of the 1,026 level and our 61.8% fitted retracement level, traders that put on a hedge position (perhaps buying a protective put) in the SPX are glad they did. Once a hedge is put on, its generally not lifted until some type of resistance is broken to the upside, or the hedge begins losing its effect as it relates to the portfolio. For instance, an investor that held $10,000 worth of an S&P 500 index mutual fund, but couldn't sell the mutual fund until the close of Monday's trading may have bought a December 1075 put (SPQXO) on Monday to protect that investment for $75. An institution that held multiple positions slated for longer-term may have done the same thing, but to a larger scale. In essence, they bought an insurance policy that helped protect against a decline below 1,000 (1075-75=1000).

Now that SPQXO is trading at the $138 level and the hedger has some choices. They could lift the hedge by selling the put for a profit ($6,300 less commissions assuming 1 contract), but they have their eye on our 80.9% retracement level at 938. Should that level be broken, the hedge goes back on, as risk then becomes 850.

Should the hedge be removed near the retracement level at 938 (current trading) the trader believes that a rally should occur. That rally level (based on retracement) would be near psychological resistance of 1,000 or retracement at 1,026. Should that scenario occur, the trader then is sitting much better as they've successfully put money in their pocket (from the sale of the put option) and could then implement the hedge once again or simply sell their mutual fund (or underlying stock positions for an institution) on the rally.

Another scenario is to do nothing! Once the hedge was put on with the put option, the trader may have looked at the hedge as insurance and would only lift that hedge should a level of resistance be broken.

As you can see, this type of trading is very much like an on off switch. It's very systematic and is only based on levels. As we've explained before, this is exactly how market makers trade.

Yes, market makers and professional trader were watching last night Presidential address, but this morning they were trading levels. Perhaps like those levels outline above. They're strategies can be complex, but they can also be as simplistic as buying a put option.

While some subscribers are "turned off" that they couldn't afford to buy a put option to hedge, we also mentioned the possibility of selling deep in the money calls. Some problems with selling the deep in the money calls in a declining market is that there are not deep in the money calls to be sold as the stock or index is reaching levels not seen in years.

This is an IMPORTANT point for future investment decisions. Now that everyone knows about the hedge strategy and learning how to use it, it's only good if there are available options to be traded on the stock. Believe it or not, some institutions only buy/short stocks that trade options! Surprised? You shouldn't be. Institutions will often times only trade/buy/short stocks that have listed options so that they can turn to that part of the market and reap its benefits.

The above was slated toward hedging, but it should also be giving every subscriber some insight into the markets perception of how the SPX can trade going forward. Try outlining some trading scenarios for yourself with "if, then, else" type of statements.

"If" this level is broken "then" do something, "else" do something. If you're an electrical engineer or computer programmer you know what I'm talking about. Trading can be very much like programming a computer. This is one reason why computer buy/sell programs are used. Computers don't have emotions and sometimes this can be a good thing when it comes to trading.

My market analysis based on if, then and else

"If" a bullish trader is willing to take some risk to the 938 level then he/she can be bullish. "Then" if a rally occurs in the SPX to the 1,000-1026 level they should systematically move up their stops to help trade for a profit.

A break below the 938 level brings us to the "else" and the need to then move to the sidelines or once again implement a hedge on bullish positions.

Option Premiums

The Market Volatility Index (VIX.X) has spiked again today and option premiums are jacked up! Current option strategists understand that now is a better time to be SELLING premium than it is to be BUYING it.

Market Volatility Index - Weekly Interval

The VIX gives hint that market participants are reaching "panic" mode and this has jacked up the premiums on options. While the above is a weekly interval, you can see from this week's single bar how premiums have exploded!

A trader that begins correlating the VIX with some retracement levels can make some good risk/reward decisions based on the S&P 500 (SPX.X) like we've shown above. In essence, at SPX 950, a bullish trader perhaps selling some puts is doing so, but only to the extent that the SPX stays above the 938 level. They're using the higher put premiums (as indicated by the VIX) to their advantage, but their trading is short-term oriented at this point. Their full concentration is on the security they're trading, but they're also keeping an eye on the SPX and levels identified, along with the VIX. If you're selling some puts when volatility and premium is high, then you look to buy them back when volatility and premium declines. It helps to have the underlying security also move higher, so stick with some stocks that are in bases, where there's been sponsorship before. Get as many odds stacked in your favor as possible!

Jeff Bailey
Senior Market Technician

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