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Hedging Your 401(k)


Brian Cox
1/31/09

              Nature is trying very hard to make us
              succeed, but nature does not depend on
              us. We are not the only experiment.
               - R. Buckminster Fuller
Protecting your 401(k)




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Protecting your 401(k)
With many 401K plans you have the
  ability to select from mutual funds,
  stocks, bonds, money market
  investments or some mix from above.

There is some nice reference information
  on Wikipedia at:
  http://en.wikipedia.org/wiki/401(k)


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Protecting your 401(k)
As you know, money is invested on a
  regular basis. The downside is that you
  do not have the flexibility of an
  individual trading account.

Most of the instruments that you can
  select from are are heavily correlated
  to market indexes



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Protecting your 401(k)

                     Don’t you wish
                     that you could
                     keep your
                     401(k) from
                     turning into a
                     201(k)?




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Protecting your 401(k)
While there is not much you can do with
 the your 401(k) as the market drops;
 but what if you were able to do offset
 the loss with something that goes up,
 as the 401(k) goes down?

This is referred to as hedging.




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Protecting your 401(k)

In finance, a hedge is a position
   established in one market in an
   attempt to offset exposure to the price
   risk of an equal but opposite obligation
   or position in another market.

    http://en.wikipedia.org/wiki/Hedge_(finance)



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Protecting your 401(k)




                     Self Directed
          401(k)     IRA
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Protecting your 401(k)

    One way to create the hedge is
    to sell credit spreads in your IRA
    account to offset the 401(k) loss
    in value.




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Protecting your 401(k)
Don Kaufman (ThinkorSwim)
instructor, suggested selling vertical
call spreads, within the 30-40 delta,
every month.
That way, if the 401(k) drops or goes
sideways, you are collecting income,
if the 401(k) rises significantly, the
hedge gets hit, but the 401(k)
increases in value.
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Step 1 select equiv index/etf

First determine an equivalent
index(s)/ETFs that mimic you’re the
mutual funds in your 401(k). Typical
ETFs that are SPY, QQQQ, DIA, IWM.
The following slide shows that many
mutual funds have a beta close to 1
when compared to the S&P 500.


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   Step 1 (continued)

                    Stock index funds                           Type                symbol   SPX Beta
Fidelity 100 Index Fund                               Large growth                FOHIX        1.00
Fidelity Small Cap Enhanced Index Fund                Foreign Large Blend         FCPEX        1.00
Spartan Extended Market Index Fund - Investor Class   Mid-Cap Blend               FSEMX        1.12
Fidelity Canada Fund                                  Regional/Country Specific   FICDX        1.02
Fidelity Emerging Markets Fund                        Emerging Markets            FEMKX        1.30
Fidelity International Small Cap                      Broadly Diversified         FISMX        1.10
Fidelity Equity-Income Fund                           Large Value                 FEQIX        1.10
Fidelity Magellan Fund                                Large Growth                FMAGX        1.11
Fidelity Puritan Fund                                 Moderate Allocation         FPURX        0.96


  Most funds, despite their names will tend to mimic
  existing indexes (SPX, DJI, Russell 2000, NASDAQ.
  The above funds are closely correlated to the S&P
  500 (beta close to 1)

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 Step 2 – calc equiv number of shares

Determine the equivalent number of shares that
the 401(k) represents.
If the 401(k) total value is $83,000 and it mimics
the SPY ($83), then the equivalent shares is:


83,000 / 83 = 1000 shares
Convert it to number of contracts
1000 / 100 = 10 contracts


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 Step 3 – execute trade

Execute the vertical call spread in the 30-40 delta
range.




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Technique: Step 3 – execute trade (cont)




The monthly income is $660 to offset any drop in
value of the 401(k) that you are hedging.


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Technique: Step 3 – execute trade (cont)


As in all option trades, close out the
trade 10-4 days before expiration and
then execute the a new spread for the
following month.
Rinse and repeat every month




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Summary

   This method of hedging is not perfect.
   It won’t cover all losses in dramatic
   drops, but is can offset some lesser
   loses and in many cases add to the
   current net value, in a manner similar
   to the covered call.




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