A Simple Hedge Strategy

10/24/02 03:06:21 PM

by Koos van der Merwe

When the market turns bearish, either close out your portfolio or hedge it in the options or futures market. These strategies are normally for players who know what they are doing, are experienced and have been able to open an options or futures account with their broker as a sophisticated trader.

Security: N/A
Position: Hold

There are many traders who are not experts in calculating hedging strategies, or brokers, who, when handling client portfolios, cannot place a client in a more risky portfolio because of their age or lack of market knowledge and experience.

How do you then protect your portfolio, other than going into the money market or buying bonds? Both are offering very low yields in this low interest rate climate and only the risk averse will tackle something that offers a higher yield but has a low (BBB or less) rating.

A hedge of funds?

Graphic provided by: AdvancedGET.

In looking around, I found that certain mutual fund companies offer high income funds which not only pay good returns, but also have a rising NAV as the market falls. They are low risk in that the risk is to move out of them when the market starts recovering as they appear to almost mirror image the market. You can see this on the chart.

To explain the chart, I have added two high income funds, namely Guardian High Income Fund and Talvest Millenium High Income fund, together in a spread using the program GET. Both funds are Canadian Income Trust Funds. To determine their performance against the S&P 500 index, I then divided the S&P 500 into the sum of the two mutual funds. In other words:

(Guardian High Income Funds + Talvest Millenium High Income Funds) /S&P 500.

I chose the S&P 500 rather than the Toronto Stock Exchange because the latter is too heavily weighted towards resource stocks. Also, the TSX usually follows the American markets.

The result is the top chart. I then drew a JM internal trading band (see Traders.com Advantage article "Technical Simplicity", posted Sept. 26, 2002) to indicate buy and sell signals. As long as the chart was above the upper band and rising, I should stay in high income funds. The capital gains plus the distribution received gave them almost a 12 percent return and at low risk, far better than the 4 - 6 percent received on a low risk bond if you are lucky, or a 9 percent on a high yield but risky junk. The disadvantage is that if you were able to get a good rate on a bond you could hold it to maturity and the principle is guaranteed. With the fund strategy as outlined above, you have to monitor the market, and close out a position as the market recovers.

Looking at the chart, I have shown the high yield funds on the top chart, and the S&P 500 on the bottom chart. You can see how the high income chart dipped every time the S&P 500 recovered, yet DID NOT GIVE A SELL SIGNAL. Was this an indication that the main trend was still down? Could this strategy be used to determine market direction? Why not? One is, in effect, measuring investor sentiment.

Finally, I placed a stop-loss (12%) from the new high on each of the funds, so I would receive either a stop-loss sell or a JM sell should the NAV fall below the lower blue band line, whichever comes first.

Koos van der Merwe

Has been a technical analyst since 1969, and has worked as a futures and options trader with First Financial Futures in Johannesburg, South Africa.