Wednesday, March 21, 2012

The Dangers of Anticipating a Market Reversal

Raise your hand if you are anticipating a bearish reversal in stocks in the near future. Great. Lots of hands here... Now let’s be honest, how many were also expecting a reversal a week ago? a month ago? ever since the calendar turned to 2012?

Market reversals are notoriously difficult to predict, which is part of the reason why many successful investors stick exclusively to trend following strategies. If one bets on a market reversal such as a correction during a bull market and it doesn’t happen, not only is there a loss associated with a short position, but there is also the opportunity cost of not having participated in the rally.

The worst part of trying to anticipate a market reversal, however, can be the psychological damage. If an investor thinks that a market is overbought or overvalued, then gets short and covers that short after the market continues to rise, they often subsequently have to wrestle with a mental block that makes it even harder to get long in a market that now appears to be even more overbought/overvalued.

So what is a savvy investor to do when he or she believes that stocks have risen too far too fast?

One approach is a stock replacement strategy. This approach consists of selling existing long holdings and replacing these with equivalent long call positions (1 contract for every 100 shares held.) A stock replacement strategy allows an investor to participate in any subsequent bullish moves, yet limits losses to the cost of the options purchased. While all stocks and other securities do not have options associated with them, there are always index options and options on a wide range of exchange-traded products (ETPs) available that are close approximations for the original holding.

For investors who think stocks are more likely to tread water than correct sharply, covered calls (or buy-write strategies) are an appropriate strategic choice. Here there are ETPs which can execute such strategies, the most popular of which is the PowerShares S&P 500 BuyWrite Portfolio ETF (PBP).

A third approach might be to rotate into less volatile holdings such as the popular PowerShares S&P 500 Low Volatility Portfolio ETN (SPLV).

Investors who are looking to hedge their existing long equity positions without rotating into options, covered calls or low volatility holdings might want to review my recent Dynamic VIX ETPs as Long-Term Hedges, which focuses on VQT and XVZ.

Quite a few talented investors have missed out on the 2012 rally and despite what you hear on CNBC or read in your favorite financial publication, there is no guarantee we will get a big pullback anytime soon. In the meantime, there are a number of approaches that will allow investors to benefit from any continued bull moves, while minimizing downside risk. In addition to some of the approaches outlined above, the links below should be a good source of information for explaining some alternative approaches as well as the nature of the recent market moves.

Related posts:

Disclosure(s): long PBP and XVZ at time of writing

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