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From rising oil prices to falling demand for copper, several signs point to a potential market downturn.

As the selling rolls into the market today, I am trying to look for hedging opportunities. I am a bit surprised that the Market Volatility Index (VIX) isn't a bit more elevated, but the futures roll on the S&P 500 may be partly to blame. So how do you get through this? Close your eyes and hope? Well, that usually doesn't turn out so well. I've been using the InterETF model for well over a year now, and even though there are some bumps and gyrations along the way, it does present some unique hedging opportunities. But each portfolio is unique, so I thought I would take a look at one possible pair and break it into three concepts: the hedge, the trade for profit and the combination.

The simplest starting position is looking at a pair designed to chase a profit. When the market is off sharply, as it is today, I like to look for a bullish type of pair with the Direxion Daily Small Cap Bull 3x Shares ( TNA) and Direxion Daily Small Cap Bear 3x Shares ( TZA) usually first on my go to list. With the volatility in the market, I want to go out as far as I can on the options chain for the two securities. I first start with my intended short position, which will be April TZA calls; therefore, I am looking at shorting TZA April 60 calls. These are 46% out of the money, but they are leveraged, so I look at the trade as being about 15% out of the money on the underlying index. I am comfortable with that amount of room on the Russell 2000 through April expiration. Therefore, I will sell these calls for $0.90 each. Given the current prices of TNA and TZA, I will sell about 1.85 calls for each TNA put I intend to purchase. In this case, I will be buying TNA April 43 puts for $0.50. Based on the current prices, if TNA and TZA move in line with each other, TNA will get to $43 before TZA reaches $60. Unfortunately, it isn't that simple, as compounding could work for this position or against it, but there is lots of room to maneuver. Providing a net credit around $1.12, there is the potential to close the trade early as time passes if these move sideways or the market moves higher. This is a bullish trade aimed at making a profit.

Moving to a hedged setup, I would sell twice as many TZA calls, so 3.7, and buy 1 each of a TNA April 43 put and April 60 put. This trade should not have any net cost even after commissions. In some cases, it may bring in a small net credit of a nickel or a dime. The trade is still hedged to the downside like the first position, but if TNA reaches $43 as TZA hits $60, one of the TNA puts will be very far into the money. In fact, the April 60 put is only about 22% out of the money, or half the distance of the short TZA calls. The market falls into April, this trade could become worth more and more as TZA approaches $60, but doesn't cross it. This is a hedge but it has some risk since a complete collapse in the market or the path of the move could threaten profitability if TZA goes over $60. However, the higher strike TNA call provides a wide safety net to give the holder options if the market falls drastically.

The last approach would be a combination of the two. Rather than a pure-hedge or a pure-profit setup, I could sell the TZA calls and buy TNA April 51 puts at $1.15 rather than the TNA $43 puts. The net credit could be cut in half, but the long TNA call is only 33% out of the money, which is still much closer than the short TZA calls. Plus, the net credit received, about $0.50, still provides some profit potential or credit to use for other hedging opportunities.

What I like most is having a pony that isn't just a single-trick animal. The ability to bend and alter the strategy to fit multiple situations makes this setup more like a workhorse than a one-trick pony.
At the time of publication, Collins was long TNA puts and short TZA calls.

Timothy Collins has worked as a financial adviser since 1999, focusing on portfolio customization, with a concentration on correlation arbitrage and risk-managed growth. He started Collins Capital Advisors in 2007, which has evolved into TangleTrade Management, LLC. TangleTrade is an RIA firm dedicated to formulating customized risk-managed investment strategies for individuals and small businesses. TangleTrade Management now manages the TangleTrade Fund, a correlation arbitrage hedge fund utilizing the trademarked InterETF strategy.

Prior to joining his first firm, American Express Financial Advisors, in 1999, Collins worked as a staff accountant for United Information Systems in Bethesda, Md. He has also worked as a financial analyst for Securities Pricing and Research in Annapolis, Md. Collins is a graduate of McDaniel College (formerly Western Maryland College), with degrees in business administration, economics and sociology and is a winner of the Bates Prize.