Hedge Clarification—For One Reader

One reader has been trying to repeatedly post some rude commentary to this blog. Of course, as is the case with spam attempts and nasty comments, they don’t get published; they go directly where they belong—in the trash can.

Since this will be the last post for 2009, I want to clean the table and address the issue.

The reader was questioning as to why I don’t implement a sell stop strategy for a hedge and, in not doing so, accumulate thousands of dollars in losses. Obviously, that is not the case, so a clarification is in order.

As I wrote in my e-book “The SimpleHedge Strategy,” in order to evaluate a hedge, it needs to be set up on a matrix to properly evaluate it. Here’s one, which I initiated when the markets were in dire straits back on March 2, 2009:


Click on graph to enlarge]

In this case, the hedge consists of a short component and two long components. The idea is that the short component will lose in value if the market rallies, while the long components gain, hopefully at a larger rate than the losses on the short side; and vice versa.

This is exactly what happened. During the study period shown (bull market), the short side lost -40.85% while the long sides gained +89.29% and +64.32% respectively. The net result was a gain of +12.82%

So, how does a sell stop work within these parameters? Very simple. A sell stop in a hedge applies to the performance of the “entire” hedge and not just to one of its components.

The entire hedge never dipped into negative territory, let alone came close to the usual 7% sell stop, as you can see by the red arrow. It only reached a low point of +0.24% on 3/30/09.

The reader apparently had an issue with the short position losing 40.85% and thought it should have been sold the moment a 7% drop had occurred. That’s not the idea of hedging, because the moment you do that you are outright long.

With the benefit of hindsight, that would have been a good move. However, at issue is not whether to be long or short but how do use a sell stop when a hedge strategy is implemented.

To this reader, I suggest to adopt a more courteous tone of voice in 2010, if he ever wants to receive constructive feedback.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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