Tag Archives: positions

Improve Your Volatility Trading By Listening To The Curve

Summary Successful volatility trading requires you to understand the futures curve. There’s more to the volatility curve than just contango and backwardation. The futures curve is telling you what the market believes about the duration of the disruption. This article is for intermediate volatility traders who already understand the various exchange-traded volatility instruments. Whenever volatility spikes, Seeking Alpha readers are presented with a spate of articles suggesting that they should go short volatility. Frequently, this is a good trade. But not today. If you learn to tell the difference between these situations, you can optimize your volatility trading returns. The past couple of weeks have been rough for volatility traders. After nearly four years of declining volatility, the broader markets decided that a long-expected correction was finally in order. Consequently, volatility spiked in mid-August and remains elevated to the time of this writing, gutting the typical short volatility trade (e.g., shorting VXX or UVXY , or going long their inverse instruments, XIV or SVXY ). Simple Volatility Trading Strategies Failed Unfortunately, over the past couple weeks, Seeking Alpha readers were bombarded with a series of articles with titles like (paraphrasing): Now is the Time to Short Volatility The Volatility Short is Ready Again Short Volatility Now Many of these articles are based on simple volatility trading strategies, such as: Go short when the VIX is above 20, or another magic number the trader happens to like. Exit when the VIX is below 14 or so. If you’re very brave and the VIX is very low (say 11 or 12), reverse and go long volatility. Other authors use the VIX futures curve and look at contango and backwardation. For instance: Go short whenever the futures curve goes into backwardation. Exit when it goes back into contango, possibly after a few days delay to eek out a better return. Some authors use standard stock indicators like MACD, stochastic, or RSI to detect elevated prices of VXX or UVXY and then go short, selling when those indicators return to “normal.” Still others recommend the reader just buy into XIV or SVXY and hold for a long period, ignoring the smaller spikes or using them as periodic entry opportunities. At some level, you can’t fault these authors. For the past few years, whenever volatility has spiked, going short volatility using one of these simple strategies has been a reasonable tactic. Unfortunately, readers who blindly followed these strategies during the last month have seen their positions crushed with massive losses. XIV is down more than 50 percent from its high in early August, for instance, and could easily fall another 50 percent over the next couple of weeks. XIV data by YCharts If you were unlucky enough to short UVXY a couple weeks ago, you saw it triple, and nearly quadruple at its recent high, possibly leading to margin calls and other unpleasant conversations. UVXY data by YCharts What happened? Could these losses have been avoided? The simple answer is “partially.” Most experienced volatility traders, myself included, lost some money during the first few days of the spike by going short. But for those in the know, it was small in comparison to what it would have been if we had held. These traders exited their positions quickly when it became apparent that this was not a short-term spike. Some, depending on their risk tolerance, may have actually made significant gains by reversing their positions and going long. What signs tipped them off? Listen to the Futures Curve If you’re going to take your volatility trading to the next level, you need to understand the futures curve. Most volatility traders know about vixcentral.com and use it to understand whether the futures curve is in contango or backwardation, but the analysis often stops there. The reality is, the futures curve is giving you information about the market consensus for volatility in the future (yes, I know that sounds obvious). First off, it’s important to remember that VIX futures act as a sort of insurance system for the equities markets. Traders who are long equities will often buy VIX futures as an “insurance policy” (a hedge) against rapid market drops just like those we’ve seen in August. Speculators typically take the opposite side of that trade, selling “insurance” and harvesting a risk premium when the markets are flat or up. It’s the time dimension of VIX futures that we’re most interested in for this article. Specifically, while the VIX may shoot skyward for any number of reasons, traders in the VIX futures market are always evaluating whether the market disruption causing the VIX spike is likely to be a short-term or long-term event. For instance, if the market believes that the disruption will be very temporary, then only the front month VIX contract will rise significantly and go into backwardation. Equities traders will buy a near-dated contract to best hedge their positions, pushing prices up. Short sellers (the insurance sellers) will demand more risk premium for the front month, allowing it to rise, but will still compete aggressively for the far-dated contracts, keeping those prices suppressed. When the market thinks the spike will be short-lived, the futures curve tends to look like this, from March 14, 2014: (click to enlarge) On the other hand, if the market believes the disruption will be longer term, more of the futures curve will go into backwardation. Equities traders will buy far-dated contracts to protect their positions out in time. Similarly, short-selling insurance salesmen will demand a greater premium for far-dated contracts to protect themselves. Thus, when the market thinks the disruption will be longer, the futures curve tends to look like this, from August 4, 2011. (click to enlarge) In extreme cases, the whole futures curve will go into backwardation. We saw this in 2008, for instance. This might be interpreted as the market saying, “We don’t have a clue when this is going to end. It’s just going to be bad for a long time.” During November of 2008, the curve looked like this: (click to enlarge) Lessons for Volatility Traders The main lesson here for volatility traders is that the shape of the futures curve is determined by the “wisdom of crowds” effect, with all traders in the market making an estimation about the duration of the market disturbance. The longer the perceived disturbance, the more months of the VIX futures curve that will be pushed into backwardation. There are a few important caveats here: The number of months of backwardation is only a rough indicator. It does not tell you exactly how long the duration will actually last. If the first two months are in backwardation, it doesn’t mean the disruption will last for two months. If we could predict the markets with that level of certainty, nobody would make any money as they would be perfectly efficient. The best you can say is that when just the front month VIX futures contract is in backwardation, the market currently believes (see the next point) the disruption will be relatively short. When more contracts are in backwardation, the market currently believes the disruption will be longer. Short-lived VIX spikes typically don’t drive the futures curve into more than a month, possibly two, of backwardation (I say “typically” because sometimes you will see multiple months of backwardation associated with a short spike, but it resolves itself within a day or two). Conversely, long-lived market disruptions like we saw in 2008 or 2011 force many more months of backwardation. The upshot is, when you see many months of backwardation in the curve, the futures is market is telling you to prepare for an extended period of volatility. The market consensus reflected in the shape of the futures curve changes day by day, minute by minute, as the market takes in more information. Typically, the front month contract will go into backwardation first and then subsequent months will go into backwardation as the market develops a belief that the disruption will be longer lasting. This may take place over days or even weeks. But the markets are also fickle. If new information arrives that suggests that what the market thought was going to be a long-term event will resolve itself quickly, you can see two or three months of backwardation go back into contango within a day or two. You need to watch carefully. This is why many volatility traders went short at the start of the August disruption; only the front month was in backwardation and it looked liked a temporary spike. Days later, the second and then the third month went into backwardation, suggesting that this was more than a short term event. Savvy volatility traders exited at that point, bruised but not bloodied. What About Buy and Hold? “But so what?” I hear many volatility traders say. “I sold short a couple weeks ago. Yea, I didn’t time it very well, but I’m not worried. The VIX is ‘mean reverting’ (not in a formal statistical sense) and it’ll eventually return to ‘normal’ and I’ll recoup my losses.” Is that a bad strategy? Well, the best that can be said is that these traders are probably right, but they are in for a rough ride. A buy and hold strategy for volatility is a lot like holding equities in 2007 and 2008 on the theory that the market always recovers. That’s probably true, but it can be a long, painful road back to break-even. Further, the opportunity cost during that time can be tremendous. Equities traders who exited the market in 2007 or early 2008, at the first sign of trouble, and didn’t reenter until mid-2009 recouped their small losses faster than those who held straight through the worst of it. Their returns remain far ahead of their buy-and-hold peers to this day. The same is true with volatility trading. If you can cut your losses short, bide your time, and then reenter the market when things are going your direction, you’ll be far ahead of those who hold through the worst of it. Also, remember that losses with exchange-traded short volatility products become “permanent” the longer the futures curve remains in backwardation. In other words, while the level of the VIX influences VIX futures, exchange-traded volatility instruments (e.g., VXX, UVXY, XIV, and SVXY) are really investing in a rolling set of VIX futures with a limited lifetime. If the duration of the disruption was large, then even if the VIX falls back to “normal,” the prices of these instruments will not return to where they were in early August. The share prices of the inverse instruments (XIV and SVXY) are “eaten away” by persistent backwardation during long-lived market disruptions. You may still have losses that will take you months or even years of persistent contango to recoup. Finally, every trader should remember that gains and losses are asymmetric . It takes a 100 percent gain to recover from a 50 percent loss and a 300 percent gain to recover from a 75 percent loss. What to Do Now If you recognized the signs and exited the market when this downturn started, congratulations. You probably walked away with a loss, but it could have been a lot worse. You’ll easily recoup that loss once the futures curve goes back into contango. If you bought in at the start of the spike, or even a week later, and then held to this point, you have a painful choice to make – sell or hang tough? You’re probably sitting on a large loss. Unfortunately, it’s impossible to tell whether it’s better to exit or to remain short. As of today, the first three months of the futures curve are in contango and the fourth month is flat (see figure, below). The fifth and sixth months are in backwardation and the seventh is flat. This suggests that this is going to be an extended period of volatility and we have some more pain still in store. You’re probably better off exiting and waiting for contango to return before you reenter. You might be even better off going long volatility (long VXX or UVXY) if the markets remain volatile. But be careful here! Volatility is very sensitive to market sentiment and going long against the natural short bias of volatility is always risky. There are no good answers here. (click to enlarge) In either case, make sure you listen to the volatility futures curve the next time and take appropriate action, swift and sure. Finally, if you’re interested in trading volatility, I invite you to follow me here at Seeking Alpha. Just click the “+ Follow” link up at the top of this post, by my name. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in UVXY over the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

The Time To Hedge Is Now – Or Is It Too Late?

Summary Brief overview of the series. Will equities continue falling further on Monday? Things to remember about this strategy and hedging in general. How are we doing so far? Discussion of the risks inherent to this strategy versus not being hedged. Back to August 2015 Update Strategy Overview It is not too late to hedge, but doing it cheaply is getting harder. Most of my positions are working, but not all have shifted into gear yet. I will discuss this aspect of the strategy a little later. But the positions I listed in the August Update have already jumped by an average of 75.7 percent in just three weeks. But this, as series followers know, could be just the beginning. If you are new to this series you will likely find it useful to refer back to the original articles, all of which are listed with links in this instablog . It may be more difficult to follow the logic without reading Parts I, II and IV. In the Part I of this series I provided an overview of a strategy to protect an equity portfolio from heavy losses in a market crash. In Part II, I provided more explanation of how the strategy works and gave the first two candidate companies to choose from as part of a diversified basket using put option contracts. I also provided an explanation of the candidate selection process and an example of how it can help grow both capital and income over the long term. Part III provided a basic tutorial on options. Part IV explained my process for selecting options and Part V explained why I do not use ETFs for hedging. Parts VI through IX primarily provide additional candidates for use in the strategy. Part X explains my rules that guide my exit strategy. All of the above articles include varying views that I consider to be worthy of contemplation regarding possible triggers that could lead to another sizeable market correction. Part II of the December 2014 update explains how I have rolled my positions. I want to make it very clear that I am NOT predicting a market crash. I just like being more cautious at these lofty levels. Bear markets are a part of investing in equities, plain and simple. I like to take some of the pain out of the downside to make it easier to stick to my investing plan: select superior companies that have sustainable advantages, consistently rising dividends and excellent long-term growth prospects. Then I like to hold onto to those investments unless the fundamental reasons for which I bought them in the first place changes. Investing long term works! I just want to reduce the occasional pain inflicted by bear markets. If the market (and your portfolio) drops by 50 percent, you will need to double your assets from the new lower level just to get back to even. I prefer to avoid such pain. If the market drops by 50 percent and I only lose 20 percent (but keep collecting my dividends all the while) I only need a gain of 25 percent to get back to even. That is much easier than a double. Trust me, I have done it both ways and losing less puts me way ahead of the crowd when the dust settles. I may need a little lead to keep up because I refrain from taking on as much risk as most investors do, but avoiding huge losses and patience are the two main keys to long-term successful investing. If you are not investing long term you are trading. And if you are trading, your investing activities, in my humble opinion, are more akin to gambling. I know. That is what I did when I was young. Once I got that urge out of my system I have done much better. I have fewer huge gains, but had also have eliminated the big losses. It makes a really big difference in the end. A note specifically to those who still think that I am trying to “time the market” or who believe that I am throwing money away with this strategy. I am perfectly comfortable to keep spending 1.5 percent of my portfolio per year for five years, if that is what it takes. Over that five year period I will have paid a total insurance premium of as much as 7.5 percent of my portfolio (approximately 1.5 percent per year average, although my true average is less than one percent). If it takes five years beyond the point at which I began, so be it. The concept of insuring my exposure to risk is not a new concept. If I have to spend 7.5 percent over five years in order to avoid a loss of 30 percent or more I am perfectly comfortable with that. I view insurance, like hedging, as a necessary evil to avoid significant financial setbacks. From my point of view, those who do not hedge are trying to time the market. They intend to sell when the market turns but always buy the dips. While buying the dips is a sound strategy, it does not work well when the “dip” evolves into a full blown bear market. At that point the eternal bull finds himself catching the proverbial rain of falling knives as his/her portfolio tanks. Then panic sets in and the typical investor sells after they have already lost 25 percent or more of the value of their portfolio. This is one of the primary reasons why the typical retail investor underperforms the index. He/she is always trying to time the market. I, too, buy quality stocks on the dips, but I hold for the long term and hedge against disaster with my inexpensive hedging strategy. I do not pretend that mine is the only hedging strategy that will work, but offer it up as one way to take some of the worry out of investing. If you do not choose to use my strategy that is fine, but please find a system to protect your holdings that you like and deploy it soon. I hope that this explanation helps clarify the difference between timing the market and a long-term, buy-and-hold position with a hedging strategy appropriately used only at the high end of a near-record bull market. Will equities continue falling further on Monday? This is the $64 million question, is it not? Consider this: the three major indexes all closed at the daily lows. Momentum appears to be to the downside if there is any carry over from the panic selling on Friday. Volume was also the heaviest near the close. I did a little analysis of how many stocks fell how much for both the S&P 500 (NYSEARCA: SPY ) and Dow Jones Industrials (NYSEARCA: DIA ) and the results were interesting. In the Dow there were 22 of the 30 component companies down more than 10 percent; 14 down more than 15 percent; and 10 down more than 20 percent. For the S&P 500 the results were also quite dramatic: 348 down by more than 10 percent; 236 down more than 15 percent; and 153 down by more than 20 percent. This was after just four down days! Oh, and the market breadth, as can be expected, was horrible with zero new 52-week highs and 627 new 52-week lows on the NYSE. Of course, that is not an indicator; but it is an ominous result. Why did investors all head for the doors at the same time? Many investors have accumulated huge gains in a relatively small number of stocks. The momentum was favorable for a long time and it just kept churning higher without apparent regard to valuation. Several issues got way ahead of where they belonged based upon respective future prospects. Investors were willing to pay as much as double what they should have been willing to pay for expected levels of growth. What was the catalyst that started the slide? I think that concerns over global demand have finally caught the eye of Wall Street. China is not growing at anywhere near the seven percent rate officially reported. Chinese officials claim that domestic consumption is growing at a ten percent pace this year. If imports are down and manufacturing output is down, then what are those consumers buying? Domestic consumption is one of the key inputs into GDP growth calculations and it is the one piece of the pie that external observers cannot find a proxy with which to measure it. Shipping tonnage into the country tells us much about imports. Exports are measured by all the receiving nations. Manufacturing is measured using the Purchasing Managers Index, which has stubbornly remained in contraction territory. Retail sales and services data are all collected and reported by the Chinese government. It is the one thing government controls and can manipulate. I just do not see how consumption can grow ten percent when there is no concurrent growth in imports or manufacturing. The other concern is how low will the price of oil go and what impact will it have on the energy industry? I have written extensively on this recently in my “Energy Sector Outlook” series and other articles, the links to which can be found here . The price of WTI crude dipped under $40 on Friday but bounced back above that crucial psychological level. Will it hold? Maybe for a few days or weeks, but not for much longer, in my opinion. This video from Bloomberg expresses why I think the price for oil can go lower into fall. Finally, I want to include a link to the recent letter to clients from John Hussman. I know he has been crying wolf for a long time and many have ridiculed his diatribes about how the market will fall. In his defense, many of the most reliable indicators that have foretold previous corrections and bear markets have not worked in the current environment of artificially low interest rates and quantitative easing which have stimulated asset valuations to soar and profit margins to reach peak levels artificially. I say artificially because if interest rates were to be normalized margins would be much lower (cost of money would be higher reducing profits) and asset prices would also be much lower. He has been on the wrong side until now. But the one chart he uses from Bank of America Merrill Lynch about half way down the letter is very compelling. It shows client net buys by client type for the last week and four weeks. The only client type that is net positive in buying is corporations buying back shares. All others (Institutions, Hedge Funds and Private Clients) have all been net sellers. So, corporation have been propping up share prices and now that type of buying is likely going to dry up, too. Something to think about. In a nutshell, if equities on the Shanghai exchange continue to fall in the face of government intervention and if the price of oil cannot hold above $40 on Monday, I believe our equity markets will likely have further to fall. To go a little further, I believe that as long as those two situations continue to be negative the outlook for global equity markets will also remain negative. I am keeping my eye on those two tells to help me determine when the worst is over. You might want to do the same. Things to remember about this strategy and hedging in general First thing to remember is that this strategy is not designed to work aggressively until the broad market indices are down by 15 percent. Then the gains should really start to kick in. The second thing to remember is that these candidates will underperform the market during a recessionary period. If the equities market corrects without the U.S. economy falling into a recession, then the potential gains for these candidates will not be as great. I am protecting myself against a “major” downturn in stocks, not against a mild correction. I am still invested for the long term, so I am not hoping for a crash, but I am also not putting my head in the sand and ignoring that the potential for equities to go much lower is real. When the S&P 500 index get to a negative 15 percent from its May high, assuming we are entering a recession, this strategy will suddenly begin to kick into high gear as equities fall further. It is between a drop of 15 percent and 30 percent where most of the gains will be acquired by the positions listed in previous installments of this series. If the market firms without reaching that level and turns higher, I may be faced with yet another year of rolling our positions to situate my portfolio for what comes next. I do not give up on my strategy as it will pay off in the end. Until then, it is just insurance against a collapse. If no collapse comes (highly doubtful that central banks have finally figured out how to prevent recessions forever) I will have given up less than one percent of my portfolio per year for the peace of mind in knowing that I am covered just in case. How are we doing so far? The answer depends upon when we bought our puts and at which strikes. Overall, each set of options listed in each article are in positive territory when taken as distinct groups. Individually, some are still worth very little. I own some of both, big winners and losers. Below I list the options I have listed in previous articles since April 2015, all of which expire in January 2016. Stock Symbol Strike Price Premium Paid Premium Available Gain / Loss % Gain / Loss GT $15 .50 .10 – .40 – 80% GT $18 .55 .15 – .40 – 73% GT $20 .50 .20 – .30 – 60% GT $25 .70 .90 + 20 + 29% GT $22 .30 .35 + .05 + 17% BID $30 .50 .85 + .85 + 70% BID $35 .90 2.25 +1.35 +150% BID $31 .55 1.10 +.55 100% ETFC $15 .42 .10 – .32 -76% ETFC $17 .55 .29 – .26 -47% ETFC $20 .69 .60 – .09 -13% ETFC $25 .84 1.95 +1.11 +132% ETFC $22 .43 .78 +.35 + 81% KMX $35 .95 .10 – .85 – 90% KMX $35 .65 .10 – .55 – 85% KMX $40 1.15 .25 – .90 – 78% KMX $40 .90 .25 – .75 – 72% KMX $55 1.85 2.65 +.80 +43% KMX $55 1.40 2.65 +1.25 + 89% KMX $57.50 1.80 3.70 +1.90 +106% JBL $15 .25 .30 +.05 + 20% JBL $18 .40 .95 +.55 +138% JBL $15 .20 .30 +.10 + 50% LB $40 .50 .05 – .45 – 90% LB $50 1.00 .15 – .85 – 85% LB $56.50 1.25 .45 – .80 – 64% LB $56.50 .95 .45 – .50 – 53% LB $65.50 1.10 1.15 +.05 + 5% LB $70.50 1.85 1.95 +.10 + 5% LB $72 1.45 2.30 +.85 + 59% LB $70.50 1.50 1.95 +.45 + 30% MAR $50 1.25 .40 – .85 – 68% MAR $50 .65 .40 – .25 -39% MAR $55 .80 .60 – .20 – 25% MAR $50 .55 .40 – .15 – 27% MAR $65 1.75 2.80 +1.05 + 60% MAR $62.50 1.45 2.05 +.60 + 41% LVLT $40 1.10 .90 – .20 – 18% LVLT $42 .90 1.55 +.65 + 72% MS $25 .76 .31 -.45 – 59% MS $25 .28 .31 +.03 + 11% MS $28 .44 .61 +.17 + 39% MS $34 .92 2.29 +1.37 +149% MS $35 .96 2.80 +1.84 +192% MU $17 .60 3.55 +2.95 +492% MU $17 .40 3.55 +3.15 +788% MU $20 .49 5.90 +5.41 +1104% MU $18 .33 4.30 +4.97 +1203% MU $15 .47 2.28 +1.81 +385% MW $45 .75 .90 +.15 +20% RCL $42 1.26 .08 -1.18 – 94% RCL $50 1.22 .22 -1.00 – 82% RCL $45 .78 .12 – .66 – 85% RCL $47 .67 .15 – .52 – 78% RCL 62.50 1.45 .86 – .59 – 41% RCL 72.50 1.65 2.26 +.61 + 7% STX $40 .48 1.25 +.77 +160% STX $38 .58 .91 +.33 + 7% STX $35 .43 .55 +.12 + 8% STX $35 .52 .55 +.03 + 6% TPX $35 2.10 .05 -2.05 – 98% TPX $35 .75 .05 – .70 – 93% TPX $50 1.45 .30 -1.15 – 79% TPX $60 1.50 1.05 – .45 – 30% UAL $28 .87 .10 – .77 – 89% UAL $35 1.26 .35 – .91 – 72% UAL $37 .92 .55 – .37 – 40% UAL $32 .62 .09 – .53 – 85% UAL $37 .81 .55 – .26 – 32% VECO $20 .45 1.05 +.60 +133% VECO $20 .40 1.05 +.65 +163% WSM $55 1.90 .15 -1.75 – 92% WSM $55 1.60 .15 -1.45 – 91% WSM $60 1.65 .35 -1.30 – 79% WSM $60 1.85 .35 -1.50 – 81% WSM $60 1.25 .35 – .90 – 72% WSM $70 1.90 1.35 – .55 – 29% WSM $72.50 1.80 2.00 +.20 + 11% Some positions are already doing well, most notably Micron Technology (NASDAQ: MU ). I decided to do an account at this time because I will may not many more recommended positions for now. It seems to me that we could either have the market go down further, in which case new positions would be very expensive; or we may not have another good entry point (new market highs) before year end at which time I would begin to roll my positions to expirations further into the future. Finally, I can imagine what some readers are thinking: there are a lot of those options that are still deep in the hole. I have not given up on those positions either. If the U.S. economy enters a recession I remain confident that those stocks will fall a long way from current levels and provide decent protection. Of course, some will do better than others. Hang in there. There may be much further down to go! One final note: if enough readers request in the comments section that I list my favorite options yet again, I will follow up as quickly as I can with what I would do now if I were not fully protected. I will do a follow up article with new recommendations only if there are more than five comments from more than five individuals requesting that I do so. There are still some good options out there, but we really need to be selective now and it will cost a bit more. Brief Discussion of Risks If an investor decides to employ this hedge strategy, each individual needs to do some additional due diligence to identify which candidates they wish to use and which contracts are best suited for their respective risk tolerance. I do not always choose the option contract with the highest possible gain or the lowest cost. I should also point out that in many cases I will own several different contracts with different strikes on one company. I do so because as the strike rises the hedge kicks in sooner, but I buy a mix to keep the overall cost down. My goal is to commit approximately two percent (but up to three percent, if necessary) of my portfolio value to this hedge per year. If we need to roll positions before expiration there will be additional costs involved, so I try to hold down costs for each round that is necessary. I do not expect to need to roll positions more than once, if that, before we see the benefit of this strategy work. I want to discuss risk for a moment now. Obviously, if the market continues higher beyond January 2016 all of our new option contracts could expire worthless. I have never found insurance offered for free. We could lose all of our initial premiums paid plus commissions. If I expected that to happen I would not be using the strategy myself. But it is one of the potential outcomes and readers should be aware of it. And if that happens, I will initiate another round of put options for expiration beyond January 2016, using from up to three percent of my portfolio to hedge for another year. The longer the bull maintains control of the market the more the insurance will cost me. But I will not be worrying about the next crash. Peace of mind has a cost. I just like to keep it as low as possible. Because of the uncertainty in terms of how much longer this bull market can be sustained and the potential risk versus reward potential of hedging versus not hedging, it is my preference to risk a small percentage of my principal (perhaps as much as three percent per year) to insure against losing a much larger portion of my capital (30 to 50 percent). But this is a decision that each investor needs to make for themselves. I do not commit more than five percent of my portfolio value to an initial hedge strategy position and have never committed more than ten percent to such a strategy in total before a major market downturn has occurred. The ten percent rule may come into play when a bull market continues much longer than expected (like three years instead of 18 months). And when the bull continues for longer than is supported by the fundamentals, the bear that follows is usually deeper than it otherwise would have been. In other words, I expect a much less powerful bear market if one begins early in 2015; but if the bull can sustain itself into late 2015 or beyond, I would expect the next bear market to be more like the last two. If I am right, protecting a portfolio becomes ever more important as the bull market continues. As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other’s experience and knowledge. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: I hold at least one put option position (multiple contracts) in each of the stocks listed in this article.

Last Week’s Best Performer- Acadia Healthcare Company

Summary One of 20 ranked (#11th) as best-odds for wealth-building from coming-price forecasts implied by market-maker [MM] hedging on 6/17/2015. Its target upside price of 78.38 was reached (within ½%) on 6/22/2015’s close at $77.99 after a day’s high of $78.50. ACHC’s +7.7% gain in only 5 calendar days produced a huge annual rate, but was only one of 27 hypothetical positions closed on that strong market-performance day. Their average gain of +9¼% in average holding periods of 33 days from prior lists of top20 MM forecasts resulted in gains at an average annual rate of +166%. Let’s look at what specific circumstances created this bonanza. How to build wealth by active investing Passive investing doesn’t do it nearly as well. SPY is now up in price YTD 2015 at an annual rate of 4.5%. Market-Maker [MM]-guided active investing this year, has identified 1281 such closed-out positions as ACHC, 20 a day. They earned at a +31.4% rate. That’s some 2700 basis points of “alpha” better than SPY. Our “leverage” is not financial. Those results are all from straight “long” positions in stocks or ETFs, no options, futures, or margin. We have the “leverage” of perspective. The perspective of market professionals who know, minute by minute, what their big-money “institutional” portfolio manager clients are trying to buy, and to sell, in the kind of volume that can’t be done with ordinary trades. Not only which securities, but at what prices. And on which side of each block trade their firm is being called on to put the firm’s capital at risk to bring the transaction to balance. We get that perspective by knowing what is meant by the way the MMs protect themselves when they hedge their capital exposures. Their actions tell just how far the market pros think prices are likely to get pushed, both up and down. That perspective is an important leverage, but it is magnified by the way we use perspective on the other key investing resource that is required: TIME. Here is what makes active investing active. We not only buy, we sell. We sell according to plan. The plan is set at the time we buy. An explicit price target is set then, with a time limit to our patience for it to be accomplished. We are investing time alongside of our capital. If the sell target price is not reached by when the time limit arrives, the position is sold, gain or loss on the capital is taken, and both capital and time are ready, positioned for immediate reinvestment. Active investing keeps its capital working all the time, it does not try to time the overall market, nor does it make uncompetitive investments in the market, ones which would accept single-digit rates of return in fear of seeing a loss or having to accept one in order to keep capital and time working diligently. Perspective and time-discipline can keep the odds of having winning holdings positions in favor of active investors. Three wins for every loss is quite doable, and the ratio even reaches seven out of every eight. Here are the specifics of how it worked for ACHC Figure 1 pictures how the market-making community has been viewing the price prospects for Acadia Healthcare Company, Inc.(NASDAQ: ACHC ) over the past six months. Figure 1 (used with permission) The vertical lines of Figure 1 are a visual history of forward-looking expectations of coming prices for the subject stock. They are NOT a backward-in-time look at actual daily price ranges, but the heavy dot in each range is the ending market quote of the day the forecast was made. What is important in the picture is the balance of upside prospects in comparison to downside concerns. That ratio is expressed in the Range Index [RI], whose number tells what percentage of the whole range lies below the then current price. A low RI means a large upside. Today’s Range Index is used to evaluate how well prior forecasts of similar RIs for this stock have previously worked out. The size of that historic sample is given near the right-hand end of the data line below the picture. The current RI’s size in relation to all available RIs of the past 5 years is indicated in the small blue thumbnail distribution at the bottom of Figure 1. The first items in the data line are current information: The current high and low of the forecast range, and the percent change from the market quote to the top of the range, as a sell target. The Range Index is of the current forecast. Other items of data are all derived from the history of prior forecasts. They stem from applying a T ime- E fficient R isk M anagement D iscipline to hypothetical holdings initiated by the MM forecasts. That discipline requires a next-day closing price cost position be held no longer than 63 market days (3 months) unless first encountered by a market close equal to or above the sell target. The net payoffs are the cumulative average simple percent gains of all such forecast positions, including losses. Days held are average market rather than calendar days held in the sample positions. Drawdown exposure indicates the typical worst-case price experience during those holding periods. Win odds tells what percentage proportion of the sample recovered from the drawdowns to produce a gain. The cred(ibility) ratio compares the sell target prospect with the historic net payoff experiences. Figure 2 provides a longer-time perspective by drawing a once-a week look from the Figure 1 source forecasts, back over two years. Figure 2 The success of a favorable outlook comparison for ACHC on June 17 was not any rare magic of the moment. It just happened that enough reinforcing circumstances came together on that day to make the forecast and its historical precedents look better than hundreds of other investment candidate competitors. Those dimensions are highlighted in the row of data items below the principal picture of Figure 1. The balance of upside to downside price change prospects in the forecast sets the stage of similar prior forecasts. They were followed by subsequent favorable market price changes that turned out on that day to be competitive in the top20 ranking of over 2500 equity issues, both stocks and ETFs. On other days luck would have it that several additional stocks were included in the daily top20 lists, and then on June 22nd would reach their sell target objectives. Figure 3 puts the same qualifying dimensions as ACHC in Figure 1 together for the days their forecasts were prescient. Then Figure 4 lists them with their closeout results. Figure 3 (click to enlarge) Figure 4 (click to enlarge) Columns (1) to (5) in Figure 4 are the same as in Figure 3. Columns (6) to (11) show the end of day [e.o.d.] cost prices of the day after the forecast, e.o.d.prices on June 22nd, the resulting gains, calendar days the positions were held from the forecast date, and the annual rates of gain achieved. Several things are to be noted. A number of the positions are repeat forecast days for the same stock. This does not make them any less valid, since investors are posed with the recurring task of finding a “best choice” for the employment of liberated or liquidated capital “today” and these issues persisted in being valid competitors for that honor for a number of days. Note that they are not always sequential days. Further, the TERMD portfolio management discipline uses next-day prices as entry costs for each position. Here for Healthsouth Corporation (NYSE: HLS ) the price rose about +10% from $43.29 to $47.41 on the day. It was still included in the scorecard, although a rational investor judgment call might have eliminated it from the choices. As a result, its target-price closeout on the 22nd resulted in a diminished 0.4% gain and a +14% AROR. Also you may note that some of the closeout prices are slightly less than their targets. This is to recognize that investors often become concerned that positions getting close to their targets sometimes back away, losing a gain opportunity and the related time investment. So our sell rule is to take any gain that gets within ½% of the target price. But all exit prices are as e.o.d., so some are above the sell targets, like the 5/21/2015 Aetna (NYSE: AET ) position at $128 instead of $125+. Conclusion These 27 ranked position offerings are an illustration of how active investing takes advantage of the sometimes erratic movements of market prices. It is in the nature of equity markets that investors sometimes get overly depressed and overly enthusiastic. By being prepared for opportunities when they are presented, the active investor often can pick up transient gains that subsequently disappear. This set of stocks is not abnormal in the size of its price moves. They averaged +9.3% gains, and the 2015 YTD average target closeout gains are running +10%. What is unusual in this set is that their time investment has been brief, only 33 calendar days on average, producing an AROR for the set of +165%. Part of the explanation lies in these 27 positions all being successful in reaching their targets. The 2015 YTD target-reaching average (952 of them) took only 46 days to make +10% gains, for an AROR of 113%. The overall YTD average in 2015 is 57 days, including positions closed out by the time limit discipline, making the AROR a more reasonable +31%. But that is well ahead of a passive buy & hold rate of gain in SPY of +4.5%. The man said “It ain’t braggin’ if ya can do it.” We are doing it, have done it before, and have been goaded into this display by passive investment advocate SA contributors whose statements infer that active investors invariably lose money. That’s just not so. We are not in an investment beauty contest with those whose capital resources are extensive enough to allow them to live comfortably off the kinds of placid returns that passive investing typically provide. They are to be congratulated. Our aim is to let investors who are facing financial objective time deadlines that cannot be met by “conventional conservative investing practices” know that there are alternatives that are far more productive and far more risk-limited than they have been led to believe. Alternatives numerous and consistent through time which we intend to continue to record and display. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.