Hedging the rise in equities

Despite a recent fall in benchmark equity indices in the dying days of January, the recent climb to record after record has put many in a mindset that they do not want to miss out on any other gains. So, how can you hedge against a rising market that you may feel is already over done? 

Technical analyst, Trevor Neil, drills down to explain why there has been this rise in indices and, using the chart of Netflix, looks at a good example in the parabolic move up for technology stocks.

Neil explains that there are ways to use hedging trades to ensure that you can remain ‘long indices’ while, at the same time, trade a recognised exchange traded fund (ETF) or index that can offer protection, should there be a sharp reversal.

Defensive strategies should, according to Neil, be as much a part of a trading plan as the idea of following trends.

Defensive strategies

  • sell short S&P futures, options, short S&P ETF or even ultras
  • sector rotation
  • theme rotation
  • volatility spike protection

The rise in the S&P 500 has been broad based, but a sizable minority, shown in the bullet points below, have been responsible for the ‘parabolic’ price action recently.

Among the S&P 500 components:

  • 117 have double-digit total returns
  • 232 have beaten the market with total returns of 6.4% or more
  • 408 have shown positive returns
  • one is flat
  • 35 are down 5% or more, including five that are down 10% or more

Neil also uses relative rotation graphs (RRGs) to anticipate where future moves could develop. Here, he says, that the information technology sector (labelled as S5INFT on the chart below), on the S&P 500, is fast moving from the yellow, or ‘weakening’ quadrant, into the ‘lagging’ red quadrant on the bottom left, an area where stocks become underperforming.

Hedging equities

Conversely, those that have previously been underperforming, Neil says, will become the new leaders. Included here are utilities (S5UTIL) and real estate (S5RLST).

Whether it is ETFs or the Volatility Index (VIX), hedging should be a major part of any trading strategy.

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