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AORD head and shoulders – an example of when to hedge
Yesterday I decided to buy XJO put options to hedge my Australian stock portfolio because of what I observed as a “head and shoulders” pattern on the daily chart of the All Ordinaries Index (see $AORD chart above). This pattern is formed when the price charts make a new lower “high”. In a healthy bull market, we should be seeing a series of higher “highs”. Each time prices pull back, new buyers should be jumping in to push prices back up to new highs. $AORD made a high of 4900 in October 2009 but struggled to push above 4800 in November 2009, showing a reluctance from new buyers to continue to pay higher prices for stocks. In technical analysis, the “head and shoulders” pattern is an indication that the market may have “topped” and there is a risk that the uptrend may have ended.
Topping patterns like the “head and shoulders” or the “double top” (see my Oct 28 post for examples of this pattern) are triggers for me to either buy insurance for the stocks that I want to keep, or to sell stocks to lock in profit. Price charts can be drawn on difference time frames e.g. daily, weekly or monthly. Patterns on short-term (e.g. daily) charts are often not as reliable as patterns on longer-term (e.g. weekly or monthly) charts. The chart above is a daily price chart. You can also see a similar “head and shoulder” pattern from May to July 2009 but this pattern “failed” when prices moved back up above the “head” in July. If prices do go up above 4900, this current “head and shoulders” pattern would be deemed to have “failed” as well. If this happens, I would sell my XJO put options and suffer a small loss which hopefully would be made up by gains in the prices of my stocks. Longer term investors may prefer to look for these patterns on longer term charts like weekly price charts. I prefer to be “too early” rather than “too late” in hedging as insurance premiums tend to get higher as the risk becomes more obvious.
Below is the weekly price chart of the S&P 500 index. In December 2007, I saw the “head and shoulder” pattern which I have indicated on the chart. We decided to liquidate our entire stock portfolio based on that observation, and other reasons like the bull market had already had a three year run and we suspected the subprime crisis might be more that just a blip. Considering what happened to the market after that, it is definitely one of the best decisions that we have ever made. We sold stocks instead of hedging with put options because at that time we were new SMSF trustees and were not sure if buying options was allowed for super funds.
The Australian and Asian markets seem to have recovered from the Dubai World scare. Everyone is convinced (for now) that Dubai’s problems are quite contained and should have little or no impact on us. Well, that is what they said about the subprime problem when it first surfaced. Even though most investors are not directly exposed to Dubai’s problems, what happened there has definitely affected their appetite for risk. Dubai World has reminded investors that emerging markets have higher risk. When companies like AIG got into trouble, the US government stepped in to bail them out. Who will bail Dubai World out? The Dubai government has already said that it will not. I doubt if it can afford to even if it wanted to, considering the GDP for Dubai is only USD 50 billion per year, which is less than what Dubai World owes. I wonder how much income Dubai actually earns? They only get a tiny 6% of the oil revenues of the UAE and they do not impose income taxes on wage earners and local corporations. I guess only time will tell. In the meantime, stay safe. If you want more details on how to hedge your portfolio using options, check out our free videos on the Training Videos page of the website.
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Hi Christina
The H&S is getting pretty long in the tooth now. http://stockcharts.com/h-sc/ui?s=$aord
Though percentage wise, I think you bought the puts at the right time.
I was close to buying puts as well, but in the end I decided earnings will be up next year. While we may get a short term pull back as the market was stretched to the upside I decided that besides a black swan there was nothing to out fundamentally out there to cause a major sell-off.
All the best
Dean
Hi Dean
Yeah probably puts won’t be needed. It was also one day after the Dubai World scare so I thought better be safe than sorry. I only did a partial hedge anyway. Will close out the puts if AORD crosses convincingly above 4900 – who knows we may have other sovereign debt “shocks” out of Europe like Greece or Latvia. I don’t even consider these black swans anymore – more debt defaults are inevitable. It is a question of “when” rather than “if” to me.
Christina
[...] as mentioned in my last post on the head and shoulders pattern, patterns on short-term charts are not as reliable and we should look at long-term charts [...]