The Pinnacle investment team has been patiently waiting for a serious correction in the recent torrid bull market for months. To us, a correction in a bull market means something like a 10% - 15% decline – enough for us to feel good about buying a dip in an upwardly trending market. Unfortunately, the market has not given investors the opportunity to jump in and buy a dip for months, with the closest thing to a correction being a 7% decline that occurred from June 12 to July 10 earlier this year. But now, for the first time since July, the tone of the market seems to be changing with the market once again declining 6% from its high of 1097 on October 19th. We are going to implement a hedge position as a trade to take advantage of a possible nasty short-term correction. It seems like it aught to be easy enough to do, but…
• Should we hedge by buying a 2X position in the U.S. dollar assuming the dollar will rally on a market decline, or buy a 2X inverse S&P 500 Index fund that should earn two times the decline in the market, or buy the VIX volatility index (Chicago Board of Options Exchange volatility index)?
• If we choose the VIX, can we be comfortable with the tracking error between the exchange traded note for the VIX Index (ETN available through iPath called VXX) and the actual underlying VIX index?
• If we put on the hedge, where do we get the cash to execute the trade? We have some cash in our managed portfolios for the buy, but what else needs to be sold to take a 4-5% position in the hedge?
• We first looked at this transaction last week and since that time the VIX has had a big move to the upside. Is it too late to buy it now that it moved more than 10% higher last week?
• We executed a complicated transaction in our fixed income allocations last week and now we can’t execute the hedge trade until the prior week transactions settle. Will the market allow us to still get in while we wait the extra days for the prior trades to settle?
• One of our analysts feels like we have seen the ultimate top to this cyclical bull market that began in March of this year and so he likes the hedge trade. Another analyst is worried that we won’t get much more on this correction and doesn’t like the trade. Another analyst thinks the trade works as is.
For Pinnacle’s investment team, the details of this transaction are just business as usual.
