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Hedging: Would You Drive a Car Without Insurance?

This complimentary article from Options Profits was originally published on January 12 at 8:58am EST. Don't risk missing over 40 options trade ideas every week and exclusive commentary from over 10 experts. Click here for more information and a 14-Day Free Trial.

Have you even hopped into your car and suddenly realized that your auto insurance was about to expire, the reason being that you forgot to pay the bill? You know that cold sweat that you probably felt at that moment, thinking fast on your feet about how to solve this problem immediately? Questions hit you fast, one of them of course being "should I even drive my car right now?"

Just for fun and edification purposes relative to the options markets, substitute "insurance" and "auto" with that of a "hedged portfolio." Now think about how you feel each time you realize, maybe almost too late in thinking so, about buying downside stock market insurance before it might become the rage to do so. You watch the price of that insurance possibly instantly skyrocket. You might begin to also once again kick yourself for not locking in nice long-positioned gains. You also think back about why you did not buy those cheap puts that you thought about buying, but decided that doing so would be a waste with the stock market performing so well. Well, do you ever think that same way when you pay your auto insurance bill?

This is the time of the season when stock market gurus prognosticate about what they see in the future, mostly the next 12 months of that future. Most of these guesses are long forgotten one year hence. But, if the guru/prognosticator just happens to get lucky, that guru/prognosticator can run all around the financial television and press world, proclaiming the now proven fact that he (they all seem to be men) is prescient stock market maven. Thus, another guru is born Then presumably that guru/prognosticator will gather a growing flock together into their subscription base, and get thus enriched simply because our financial press organ today will enable such.

That's the way the permabear game is played as far as I have witnessed this phenomenon since its inception more than four decades ago. I try to use these showmen as a sentiment canary, knowing that their track record for being prescient is about as good as any fade bet can get. In fact, the higher the frequency of permabears on financial television, the closer the market is to its bottom. That being so, the opposite must be at least considered--i.e., any lack of permabear sightings is ominous.

I know it to be a certainty that the permabear conflagration is right now waiting in the wings, suitcase packed and ready to appear on financial television when the management of these stations deems their appearance to be worthy of generating higher viewership ratings. Now, the mere fact that I have not seen one of these permabears as of yet in 2012 also resounds though quietly, a few chirping signals. One signal is that, like real sleeping bears, permabears know their timing as per how it relates to: 1) growing their subscriber base; and 2) when to stay out of the limelight as they hibernate until they sense the time to strike fear and panic in the minds of investors is nigh. Thus a lack of their sighting, while bullish now is an alarm clock ticking.

If you are like me you prefer to buy your straw hats in winter. Thus possibly now is the time to buy stock market insurance because it probably will not get much cheaper than it currently is unless the stock market goes into a seriously long bull market cycle. This after all is winter. Think of put pricing now as those straw hats.

If you follow my trades posted to our Options Profits site, you will know that at times I have liked ProShares UltraShort S&P 500 (SDS) as not only a speculative options vehicle, but in addition, as an excellent hedging vehicle. You should know that being an ETF that SDS constantly resets itself pricewise and thus at times it seems to be a vehicle that is not a perfect one to one correlating hedge play. However, for the most part, the one part where options translate into real dollars, I still prefer to use SDS for hedging purposes. So consider that statement as a disclaimer. And please, as always do the homework so you have a complete understanding of this ETF as well as its underlying options.

SDS has once again set up to use to hedge the S&P 500 as the premiums being paid for the higher strike calls of SDS, especially in the "far month" series, allows for a vertical call spread to be executed at a very inexpensive dollar risk level. January 2013 is the targeted expiry. SDS is a double inverse ETF of the S&P 500. Thus as the S&P declines SDS rises at double the rate of the S&P fall (in theory).

The strike prices are 18 for the long side, and 23 for the shorted side. The spread should set up to be executed close to a $1 debit as the volatility for the 18 strike is trading around 46 and the volatility for the 23 strike is trading around 56. Go figure. And thank the effect of the unwitting permabears for this SDS skew in volatility which sets up the trade.

Trades: Buy to open SDS January 2013 18 calls for $3.60 and sell to open SDS January 2013 23 calls at $2.60.

This trade is low in dollar risk as any totally controlled risk, $1 debit for an options trade is such. This trade is medium in reward potential because it is a hedged trade which caps the upside potential. However, should the S&P close in one year from now, in January 2013 expiry period, at or below the price point where SDS is priced at 23 or higher, at that level this spread will have grown from a $1 debit to a $4 profit. That's not a very expensive risk for stock market insurance for the next 12 months.

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