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We've seen the S&P 500 move back above 3,000 for the first time since late February. It's back above its 200-day moving average, too.
For the bulls, this is good news: The technical breakthrough creates another opportunity for stocks to move higher in the short term.
So, by all means, enjoy the long-side profits. Just don't turn your back on the market. Don't rush in unprotected. This market still demands respect from investors who have even bigger portfolios to defend now; it could turn vicious in a heartbeat.
Valuations have rocketed higher, but the economic risks of the coronavirus crisis remain constant; high unemployment and extreme economic uncertainty are all but certain to persist through the summer.
At the same time, the "money migration" that was sparked by that same technical breakout above 3,000 is now lifting the financials, travel, and, importantly, small-cap stocks, is also a signal that we'll likely waltz down the primrose path into an overextended, "overbought" situation in the market.
That means hedging is more important than ever. Now, I've talked before about "paying" a little for portfolio insurance every month; that's easy to do.
If You're Not Using This, You're Throwing Away Gains
Now, we've talked about how using your cash reserves, plus simple, highly liquid inverse ETFs like the ProShares Short S&P 500 ETF (NYSEArca: SH) and the ProShares UltraShort S&P 500 ETF (NYSEArca: SDS) can protect your net worth overall even if your other holdings fall, and generate up to 27% more cash that you can either pocket or, even better, reinvest when stocks are more or less bottomed out.
(This is worth a special mention: You do not have to wait for stocks to hit absolute rock bottom before doing this.)
Other easy-to-trade inverse ETFs are the ProShares Short Dow 30 ETF (NYSEArca: DOG) and the ProShares Short QQQ ETF (NYSEArca: PSQ) that will return the inverse of the Dow Jones Industrial Average and NASDAQ 100, respectively.
You want to look after hedges like this, like mowing your lawn or feeding fish.
I like to revisit my hedges' performance once a month, at least, and if the hedge has lost money, I dollar-cost average down to get some more - insurance at a discount.
But the easiest, most basic way to hedge is the humble trailing stop.
Just like the name says, the stop order trails your position higher, locking in profits and protecting principal.
I don't understand why everyone doesn't use trailing stops. Every reputable brokerage offers them, and they're very easy to use.
Some traders put a fixed stop-loss order on a position and either forget to adjust it as the position moves higher into profit territory... or just aren't aware that they need to constantly adjust the stop higher. Here's an example...
Say you buy 100 shares of ABC at $100 and you've determined that you are going to use a 5% stop-loss exit strategy.
The stock rallies to $130 (a 30% profit), but you haven't updated your stop (still at $95).
The market reverses, and your position is ultimately closed at $95, resulting in a 5% loss when - oh, no - you had a 30% profit in the bag!
In a "mean market," trailing stops prevent mishaps like that.
Consider the same scenario - only this time, you've entered a 5% trailing stop...
The stop would've ratcheted higher along with the stock, and instead of a 30% loss, you'd have locked in profits of 23.5%.
Read that again: 23.5% guaranteed gains against a 30% loss... all because you used a trailing stop.
How? Well, at the peak of the position, your stop would have automatically trailed to a stop-loss price of $123.50.
When the market reversed, your stop was already adjusted, and instead of losing 5% from using an ineffective stop-loss, the trailing stop-loss order pumped up your profits.
The "tightness" of your trailing stop is really up to you. I find most positions do well with a 15% or 20% stop, the better to let your winners run. When volatility starts to come back, consider tightening up, to 5% or so.
Your brokerage will have more about exactly how you should enter a trailing stop-loss order; they're all a little different, but the bottom line is, with a trailing stop, you can fortify your profits at the push of a button.
And in the meantime, don't miss out on my colleague Michael Robinson's latest presentation...
You see, clinical-stage biotech firms are usually avoided, but life is far from normal right now. The entire world is hoping, praying, and relying on these firms to develop a vaccine for the coronavirus.
Over 70 companies are competing for the gold medal. In fact, Michael has made some calls to very important people in the industry and was astonished when one of them replied, "We're already planning to ship our first million doses by year's end." Find out more here...
About the Author
Chris Johnson is a highly regarded equity and options analyst who has spent much of his nearly 30-year market career designing and interpreting complex models to help investment firms transform millions of data points into impressive gains for clients.
At heart Chris is a quant - like the "rocket scientists" of investing - with a specialty in applying advanced mathematics like stochastic calculus, linear algebra, differential equations, and statistics to Wall Street's data-rich environment.
He began building his proprietary models in 1998, analyzing about 2,000 records per day. Today, that database, which Chris designed and coded from scratch, analyzes a staggering 700,000 records per day. It's the secret behind his track record.
Chris holds degrees in finance, statistics, and accounting. He worked as a licensed broker for 11 years before taking on the role of Director of Quantitative Analysis at a big-name equity and options research firm for eight years. He recently served as Director of Research of a Cleveland-based investment firm responsible for hundreds of millions in AUM. He is also the Founder/CIO of ETF Advisory Research Partners since 2007, noted for its groundbreaking work in Behavioral Valuation systems. Their research is widely read by leaders in the RIA business.
Chris is ranked in the top 99.3% of financial bloggers and top 98.6% of overall experts by TipRanks, the track record registry of financial analysts dating back to January 2009.
He is a frequent commentator on financial markets for CNBC, Fox, Bloomberg TV, and CBS Radio and has been featured in Barron's, USA Today, Newsweek, and The Wall Street Journal, and numerous books.
Today, Chris is the editor of Night Trader and Penny Hawk. He also contributes to Money Morning as the Quant Analysis Specialist.