The Problem with Taking a Hedge Position

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As you may recall last week we took a position in Proshares UltraShort SP500 (ticker:SDS) to help cushion our losses in case of a downdraft in equities.  Note that this position was meant to only cushion common stock risk– and nothing else.  Hedges like this can present problems if one doesn’t have a plan of sorts.  If you are hedging common stocks because you fear a fall in values you may be lucky to break even if you are correct (your losses on your common shares equal your gain on your hedge shares) . Additionally, if you are wrong and common stocks move higher you might  break even in total (you lose on the hedge, but gain on your common holdings).  This really is what we hope for–no matter which direction common shares move one ends up breaking even, while continuing to collect dividends on your holdings.

So what is the problem?  The problem occurs when you have a decent gain on the hedge shares (in this case SDS in which we have a 3% gain in 4 business days) and you start to believe you are smarter than the market and that equities are going to now move up.  You sell your hedge shares locking in a 3% profit (although in a perfect world you lost 3% on your holdings–meaning no net gain/loss) while leaving your holdings fully exposed to future losses. You have to ask yourself if you made the initial hedge decision with firm reasoning or if you are just gyrating around willy nilly without a firm view on where you think the market is heading (right or wrong).

Our answer is that we have seen economic numbers on a U.S. and Global basis that truly make us question the ability of common stocks to move higher.  We are not concerned with 1, 2 or 3% market moves, but are concerned with the 5, 10 and 20% market movements. In the last week we have had a downward move of about 1.5% which translates into a gain of 3% for us on our SDS hedge position as it is a leveraged 2X hedge. NOISE really and not highly meaningful.  We are HOLDING our hedge position–in general nothing has changed from the day it was put on.

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