Happy to Sit on the Sidelines

 | Apr 25, 2014 | 11:58 AM EDT  | Comments
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Stock quotes in this article:

amzn

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goog

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googl

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FB

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msft

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APPL

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sbux

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twtr

Earnings for Amazon (AMZN) are out of the way along with Google (GOOG), Facebook (FB), Microsoft (MSFT) and Apple (AAPL), among other tech names, so life can get back to normal, right? I am out of the Amazon trade from last night. I really thought it would be the ratio call spreads that were the winner, but, in the end, it was the ratio put spreads that brought in the coin. I exited that trade and every other earnings trade for that matter including the aforementioned MSFT and Starbucks (SBUX).

Honestly, on this Friday I am happy to watch from the sidelines. I see a names such as Twitter (TWTR) and have absolutely no incentive to be involved. This feels like a dangerous Friday. I am comfortable holding a cash position from time to time. It has been far more rewarding in 2014 than it was in 2013.

Utilities are still pushing to new highs, while bond yields are still trending lower. Couple these with the huge reversal in precious metals yesterday and you've got a reason to at least be cautious. If you don't have any hedges in place, I don't think it is too late to consider using them. In fact, I don't really think it is even too late to consider hedges as long as you understand the purchase.

There is a difference between buying a hedge or making a short trade or even a pair trade. A hedge is insurance. The cost of your hedge should be something you write off mentally. In fact, if your hedge is a true hedge, then you will want to lose money on the hedge itself. Think about other types of insurance. Each year, we pay for car insurance, home owner's insurance, health insurance, and life insurance, at least most of us do. Do you really ever want to have to use any of those policies (especially that life insurance policy)? Of course not. You want to pay the premium and that's it.

So, put aside the whole idea of a deductible and just look at the premium. You pay the premium in the hopes you will never need the policy. It is there in case something goes really wrong. Portfolio or position hedges should be the same. You don't want to get a benefit from them unless your thesis is wrong.

Buying puts because you think something is going lower is not a hedge. A pair trade is not a hedge. It is a separate trading thesis. You believe one position will outperform another. If you are really wrong with either of those trades, they aren't protecting anything else necessarily. Therefore, you need to understand exactly what trade you are making and feel comfortable with your hedge.

Soon enough, we'll be seeing the articles on "sell in May." Bob Byrne did some great research into this last year and actually demonstrated that there is some merit behind the thesis. However, it comes more in terms of underperformance from May through October rather than a market necessarily being lower. So if those articles scare you or a drop post earnings on multiple names worries you, then maybe you want to consider using some hedges against positions rather than just selling out completely.

Maybe that's why performance tends to drag in May. Investors are willing to pay for hedges (insurance), so they can stay in the game, but in return, are willing to accept a net lower rate of return. I don't really know. It's just a thought. But if you get comfortable with the idea that a true hedge for most is a cost of doing business or investing through perceived turbulence ahead, then you'll be better able to maintain those hedges even if they begin losing money. This action will prevent you from selling the hedge at a loss only to then witness a loss in the investment the aforementioned hedge was protecting.

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