Today I present an important lesson in “being wrong.” Very recently I wrote that the debt limit “crisis” would likely go down to the wire and that investors might consider buying call options on ticker VXX (which tends to rally sharply when the stock market falls) to hedge their stock portfolios if things got “dicey.” Well, as it turned out the Republicans caved sooner than expected and a bill was passed and as far as anyone can tell, “Happy Day are here again.”
And by the way, VXX call options fell precipitously as fear left the marketplace. So am I sitting here with egg on my face? Hardly. Here comes the important lesson, which I think is nicely summed up in:
Jay Trading Maxim #106: It is OK to be wrong in the markets. It is not OK to be wrong AND to allow yourself to lose a lot of money in the process.
So in this instance notice what I “did not” do. I did not “sell everything!” I did not “sell everything and then sell short in order to profit from the coming collapse…..”, etc.
The purpose of a hedge is to insure against some sort of adverse event. It can be equated to insuring your home. For the price of a relatively small premium you have the comfort of knowing that if your house burns to the ground you will be able to have it rebuilt. Buying call options on VXX (or put options on a stock index such as SPY or QQQ) is intended to serve the same purpose. Spend a small amount of money to insure against a larger loss.
So when danger looms an investor can – by spending a few dollars on an option – insure his or her “financial house.” If the feared adverse event does not play out, the investor will be out the “insurance” money spent to buy the hedge. Ironically, this is a good thing.
“Here ends the lesson.”
-Sean Connery as Malone in The Untouchables