Despite what the headline says, this is not one of those “Gloom and Doom” or “Sell Everything” articles. It simply serves to remind that this is not the worst time in the world to think about hedging your stock portfolio. First off, in case you have been tied up for the past 48 hours attempting to sign up for Obamacare, simply note that it is now the month of October. Now over the long-term the stock market has actually gained ground during October. But there is a reason that people refer to it as “Crash Month”. A number of stock market, um, “declines”, both large and “merely painful” have played out in the past during October.
Will this be “one of those Octobers?” Probably not, but…….for those who hold some belief in “The Power of the Negative Divergence”, there is some reason for concern. In Figure 1 you see ticker QQQ which tracks the Nasdaq 100. On 10/1 it closed at a new multi-year high. Whoohoo! As a “go with the flow” kind of guy and as a big believer in the “power of the trend” please understand that I am not attempting to “call the top”. I am merely pointing out the potential for a, ahem, “meaningful pullback.”
Under the bar chart in Figure 1, I have plotted an indicator I created (in truth I took two indicators from other people and simply mashed them together) called RSI2_DMISD. Now if I could remember what that acronym stands for exactly I would tell you, but for now simply note that this indicator does a pretty good job of “negatively diverging” near tops.
Figure 1 – Negative Divergence between indicator and price action (courtesy: AIQ TradingExpert)
As you can see, RSI2_DMISD came nowhere close to making a new high on 10/1. Does this mean the market is “doomed?” Not at all. But it does offer a word of caution. In addition, in Figure 2 we see that while QQQ and IWM (that tracks the Russell 2000 small cap index both made new highs, the large cap indexes represented by ticker DIA and SPY did not. This represents another form of bearish divergence.
Figure 2 – Nasdaq and Small-Caps touch new high; Large-Caps not so much (courtesy: AIQ TradingExpert)
Summary
As an avowed “trend follower” it is not in my nature to shout “sell everything”. It is however, in my nature to shout “Hedge” every once in a while (and boy do I get some funny looks at the grocery store). This is one of those times.
My favorite play is still to hold call options on ticker VXX which track the VIX Index. In Figure 3, the VXX has not moved up much even as the S&P 500 has declined of late. If anything “negative” happens during October we have every reason to expect VXX to “spike” higher.
Figure 3 – VXX has room to move higher (courtesy: AIQ TradingExpert)
If VXX were to merely bounce back up to its most recent high of 17.34, the November VXX 14 call would roughly double in price. 
Figure 4 – VXX November 14 Call Option (courtesy: www.OptionsAnaysis.com)
At $166 a contract, this represents a pretty good and inexpensive hedging opportunity. On the flip side, if nothing “bad” happens during October, this option can be sold on October 31st to salvage some of the premium.
Jay Kaeppel
