Volatility Hedge a Buy as Wall Street Soars

 

Yes, Virginia, there does indeed seem to be a Santa Claus rally.

After a very lackluster early December for the U.S. equity market, the final half of the month suddenly appears to be on track to recapture some of the uptrend magic that has been performing on Wall Street for a majority of 2013.

The key to a week of solid gains for the major indices was once again the Fed, as Bernanke and crew announced it would begin tapering its massive bond purchases in January of 2014.

That was apparently a gentle enough level of withdrawal from the Fed’s “easy money” for investors to feel a wave of positive sentiment.

The Dow Jones Industrial Average (DJIA) rose by a solid 3% for the week, adding 3%. The 470-point rise was the largest point gain for the Dow in close to a year.

The S&P 500 Index (SPX) performed stoutly, adding 2.4%, helping to overcome losses incurred in the benchmark index over the course of the previous two weeks.

The Nasdaq Composite (COMP), already running a four-week winning streak, notched another one in the black, this time gaining 2.4%.

The Fed’s move seemed justified as Friday’s economic data revealed that for Q3, the nation’s gross domestic product (GDP) came in at a higher-than-expected annual rate of 4.1%. The pace of growth in the GDP was the fastest in two years.

The fact that the Fed’s $85 billion per-month bond purchase program, an experiment in economic stimulus that began fifteen months ago, would be reduced by a mere $10 billion a month apparently gave investors confidence that the remaining $75 billion would be adequate to keep the market pumped up and primed.

It certainly didn’t hurt that the Fed also indicated that it would keep the benchmark interest rate at the current near-zero level, a rate that no doubt has contributed to corporate health overall.

Though Ben Bernanke was the man behind the podium for the Fed’s press conference, it would be safe to assume that the indication of a very gradual tapering was something that would continue under the auspices of the incoming Fed Chief, Janet Yellen.

The odds of Bernanke steering his final actions as Fed Chief in a contrary direction to that of Yellen are likely on the slim side, though, as is always the case with the Fed, nothing is a certainty.

Whatever the reason, Wall Street continues its assault on record highs, with the SPX now up over 27% year-to-date.

At least technically speaking, there are no barriers in the way of a continuing uptrend. And, fundamentally, with improvements in the jobs numbers and improved metrics in economic growth, new highs may continue to be posted in the near term.

But any investor that has followed the markets for an extended period should know by now that all balloons must eventually deflate and fall back to earth.

Sooner or later, a correction will occur. And when it does, investors may end up wishing that they took some risk management action during the good times.

However, the high of irrational exuberance is potent, so hedging is not always the first consideration in this sort of up-trending market. And hedging can at times be more daunting than other aspects of compiling a successful portfolio.

So, as the holidays are revving up into full swing, consider the purchase of a little volatility insurance into your portfolio.

One of the benefits to using a volatility-based derivative as a hedge is that you get a strong bang for your buck, as any sharp market move tends to be reflected in an explosive move by the derivative.

As of last Friday, the VIX sat at 13.79, which puts it slightly towards the lower end of its Year-to-Date price spectrum. As such, it can be considered to be a reasonably good value in terms of its purpose as a hedge vehicle.

One of the more widely traded of the VIX derivatives is VXX (S&P 500 VIX Short-Term Futures ETN). VXX tracks the S&P 500 VIX Short-Term Futures Index, and serves as a useful tool for shorter-term hedging.

The market may feel like it can only keep moving up. But as you contemplate what vintage of bubbly you should procure to ring in the fast-approaching New Year, remember that apple that bounced off Isaac Newton’s sleepy head, and consider a hedge for the holidays.

Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account their personal financial circumstances in acting on any rankings or stock selections provided by Daniel Sckolnik or Sabrient. Neither Daniel Sckolnik nor Sabrient makes any representations that the techniques used in its rankings or selections will result in or guarantee profits in trading. Trading involves risk, including possible loss of principal and other losses, and past performance is no indication of future results.