Hedging in a bear market

If you follow my blog, you know that I believe we have entered into an intermediate termed bear market trend. By intermediate termed trend, I mean one that could last a few months and experience a 20% + decline. Evidence for that observation was seen in my last blog here . My personal strategy has been to attempt to play out a short termed rally (short termed implying days to weeks) into the current resistance zone of 1950-2000 on the S&P500. Should you feel a continued downtrend for the intermediate term is likely (after a near-termed pop), the hedging strategies discussed below might interest you.

 

This blog briefly covers some of the basic differences between buying an inverse ETF (non leveraged) and an ETF that shorts stocks – and finally shorting a stock or an index ETF outright. I will not describe other hedging tools such as options, futures, VIX tracking ETF’s or non-correlated assets such as gold or bonds in this blog.There is enough to cover on the 3 vehicles noted.

 

To be clear–I will not be as thorough in this blog as you will need to be if you truly wish to fully understand the risks and rewards associated with these strategies. I recommend you visit the websites for the providers of the ETF’s mentioned and read the prospectus before making an investment decision. As far as outright shorting a position, I also recommend you discuss the strategy with your brokerage firm or Investment Advisor to fully understand this strategy as ETF’s mentioned are not suitable for everyone*.

 

Inverse ETF’s

In Canada, the only provider of this type of ETF is Horizons. They offer an inverse ETF that plays agains the TSX (HIX-T) and the S&P500 (HIU-T). Below is a chart of HIU against the S&P500. Note the correlation panel below the price chart of HIU – black line. This indicator shows you how negatively correlated to the S&P500 the HIU shares are. The relationship is -0.98 correlated, where -1.0 is a perfect negative correlation. Thus, at -0.98, HIU is pretty darned perfectly negatively correlated to the S&P500!

hiu

 

In order to understand the risks associated with inverse ETF’s, I copied this excellent description from Wikipedia- as seen below. Here is the link for the full Wikipedia description.

 

If one invests $100 in an inverse ETF position in an asset worth $100, and the asset’s value changes to $80 and then to $60, then the value of the inverse ETF position will increase by 20% (because the asset decreased by 20% from 100 to 80) and then increase by 25% (because the asset decreased by 25% from 80 to 60). So the ETF’s value will be $100*1.20*1.25=$150. The gain of an equivalent short position will however be $100–$60=$40, and so we see that the capital gain of the ETF outweighs the volatility loss relative to the short position. However, if the market swings back to $100 again, then the net profit of the short position is zero. However, since the value of the asset increased by 67% (from $60 to $100), the inverse ETF must lose 67%, meaning it will lose $100. Thus the investment in shorts went from $100 to $140 and back to $100. The investment in the inverse ETF, however, went from $100 to $150 to $50.

An investor in an inverse ETF may correctly predict the collapse of an asset and still suffer heavy losses. For example, if he invests $100 in an inverse ETF position in an asset worth $100, and the asset’s value crashes to $1 and the following day it climbs to $2, then the value of the inverse ETF position will drop to zero and the investor would completely lose his investment. If the asset is a class such as the S&P 500, which has never increased by more than 12% in one day, this would never have happened.

 

Short ETF

The only true “shorting” ETF that I am aware of is that offered by AdvisorShares in the USA. The Ranger bear ETF (HDGE-US) shorts a collection of stocks that the managers deem as  having low earnings quality or aggressive accounting which may be intended on the part of company management to mask operational deterioration and bolster the reported earnings per share over a short time period. In addition, the Portfolio Manager seeks to identify earnings driven events that may act as a catalyst to the price decline of a security, such as downwards earnings revisions or reduced forward guidance.”

An attractive feature of HDGE is that you are participating in a true short strategy without the unlimited loss potential of an outright short executed by yourself. Further, its diversification – often in about 40 stocks or so of the S&P500 listings- provides less individual security risk when compared to individual stock shorts. Further, the fund not only utilizes a fundamental analysis approach to identifying the most overvalued stocks within the S&P500 index, it also incorporates a separate technical analysis overlay to look for the least technically attractive stocks within the fundamentally overvalued list.

The chart below shows us the performance of the ETF vs. the S&P500. The bottom pane is again the correlation line. Note again the strong negative correlation (almost perfectly negatively correlated to the S&P500 at -0.97).

hdge

 

Shorting stocks

Not all stocks can be shorted. Your brokerage must be willing to lend the stock to you to sell. You will be charged margin interest on stocks you short, which are executed through a specific short margin account. You will also be on the hook for dividends or rights issued during the time you are short the stock. Ideally, you will want to profit on the stock falling by buying the stock back at a lower cost than when you sold it–taking into account the various interest costs, dividends paid etc. Should the stock go the other way (up) – you do have unlimited loss potential. Stocks could, theoretically, go up forever–assuming you hold the stock forever. Risk, therefore, is theoretically infinite on a short sale if you short a rising stock forever.

shortsellingstocks-800x516

Another factor to consider on an individual stock short is the potential of  short squeeze. Stocks in downtrends are often heavily shorted. At some point, somebody with serious capital behind them gets wise to the short volume and can “squeeze” the shorts by buying the stock, causing mass panic by the shorters to cover their positions. This ultimately results in a strong positive move for the stock, potentially causing a margin call or an unprofitable trade for you. For this reason, if you really like the idea of shorting, I favour shorting an eligible market index ETF. Having said that, at ValueTrend we tend to focus on the above two strategies rather than direct shorting.

 

 

Keith on BNN: Changed to Tuesday Feb. 2nd at 1:00PM

 Tune in to BNN to catch me live on BNN’s premier call-in show, where viewers like yourself can ask my technical opinion on the stocks you hold.

Call in with questions during the show’s live taping between 1:00 and 2:00 pm. The toll free number for questions is 1 855 326 6266. You can also email questions ahead of time to [email protected] – it’s important that you specify they are for me.

Keith BNN

 

 

 

 

 

*ETFs mentioned are not suitable for investors that are not interested in short-term trading and do not have good investment knowledge. These ETF’s mentioned may have exposure to aggressive investment techniques that may include leveraging, which magnify gains and losses and can result in greater volatility in value and be subject to aggressive investment risk and price volatility risk. ETFs are not guaranteed, their values change frequently and past performance may not be repeated. Please read the prospectus before investing.

16 Comments

  • Thanks for the good introduction to these hedging possibilities.

    If I understand correctly, inverse ETFs are basically single-day or very short-term vehicles. I see now more clearly see the risk entailed. Horizons offers one with 2X leverage. Things could go pear-shaped in a hurry.

    Am I right that the Ranger HDGE is the only one of the ETFs mentioned that, by its nature, suits a longer-term position? (ie if trader thinks SPY might drop over the course of few weeks or months)

    The HDGE fees are higher than I’m used to seeing in an ETF, close to 3%, but it’s a specialized product with highly active management so that makes sense.

    For someone who wants to cautiously dip their toes in the shorting side of the market, HDGE is interesting.

    Reply
    • Yes, HDGE is probably a better long termed position (assuming a long termed bear), although I am mightily impressed with the much smoother consistency in negative correlation of HIU. Over the period of time shown on the chart (3 + years) you can see a consistent correlation of near -1, with only August of this year bringing that to -.75 or somewhere near that level. HDGE on the other had can be a little more uneven in its correlation to the market, which makes sense given it is actively managed and even holds cash at times.
      The high MER of HDGE is partially justified by the fund incurring margin costs, payment of dividends if any, and of course for active managers vs. a direct inverse play on an index ETF. So yes, the fee is higher for that.

      Reply
  • Keith,

    Can standard technical analysis tools and techniques used on an inverse ETF?

    Thank You in advance for your reply.

    Reply
    • John–largely, yes, you can chart and apply TA indicators to inverse ETF’s-Shorter (daily chart) timeframes are going to be better than longer time frames-bearing in mind that there is some distortion on the daily re-balance as described by the Wikipedia insert.

      If you have a crazy swing like that of last summer’s, you get distortions. Note the correlation line on the chart for August–it swung from its usual relationship of -0.98 or so to around -0.75, then back again. Thus, for a short time period, it was less negatively correlated asset to the S&P500. Hope that makes sense.

      Reply
  • HEARD FROM A PROMINENT T.A.: “I WOULD SHORT THE $SPX MARKET ON A BOUNCE TO 1990” (EX SUPPORT/RESISTANCE LEVEL). DO YOU PUT ANY FAITH IN SUCH A MOVE?

    Reply
    • JP–not sure of the target to 1990 – that is my ultimate best case target as I have stated several times, but it may only rally to 1940 or 1950. Hence my comment in the prior blog–of a target between 1950 to 1990 for the S&P500.
      Either way, this is why I wrote the blog on inverse and short ETF’s– yes I do in fact intend to hedge out the remaining stocks I hold (after selling aggressively) via a short or inverse or both ETF.

      First thing first–sell on the rally.

      Reply
      • Seems this 1910 level is becoming key in the short term. Tested 5 X on the smaller time frame but can’t seem to break and hold above. Yet… As things seemed completely tethered to oil here, what are your thoughts on where oil is headed Keith? Is this a short squeeze rally maybe up to around 37-40 range then reality of inventories come back into play and back down?

        Reply
        • Oil – as noted for Barry’s question–needs to break $35-ish. From there, we shall see.

          Reply
          • So Keith – it sounds like you’re saying it’s too early yet to move on oil? we don’t know if it’s going to go up or down from here – possible either direction? I think oil is a great opportunity given it’s so low but just not sure what the best entry range would be.

          • Wanda- at this point I am suggesting it is a reasonable short termed trade to $35-$38 target, but as far as an intermediate termed – or long termed trade – my way of doing things is to look for a base breakout before being too confident

  • Finally 1910 is broken! Maybe now we can get a bit more of a rally and get short again next week.

    Reply
    • Great minds think alike, I hope…that’s what I’m looking at–1950-2000 = sell zone. Once it rounds over = hedge time.

      Reply
  • Wonder if we have seen the top (sell zone) and have now entered the bear market as you described here or are we bouncing off these levels back to the 1950-200 before the real sell off happens

    Thank you Keith. Love your blog

    Reply
    • Well Mike, its a hard one to call I have to admit–this looking is a waterfall market. It could find support at the “hammer” low I noted on a prior blog-about 1810 intra day lows for the S&P500 -to form a double bottom. But the daily movements of up 1-2 days then a waterfall group of down days that follow seem to mimic that of every long termed bear. So it looks to me that 1810 or so is the last stand–like General Custard or the OK Corral. If thats broken for 3 days–it’ll be ugly.

      Reply
  • Are there now available any inverse funds that may be used as a long-term hedge against a declining market? Something one can safely add to an investment portfolio and essentially forget about until that inevitable rainy day?

    Reply
    • Hi Richard–good for you in looking up this blog. The ETF’s described are OK–probably the best is the HDGE ETF in the US. They all have higher than normal costs – so time can work against you –and resets on the inverse can erode price over time. So long termed hedging is something you need to be careful with–markets tend to take the stairs up and the elevator down. In other words, if the market falls, it might not be an extended period. So when I hedge, I do so with a specific time frame in mind–and I follow the trend.

      Reply

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