The market is giving investors plenty of reasons to think that a healthy correction is waiting in the wings. From a technical perspective, the S&P 500 and other benchmark indices are flirting with what are considered technical resistance levels.
For example, the S&P 500 (SPX) is trading right at technical resistance as it is just a hair below its July 2011 highs of 1,356 (blue horizontal line in the chart below). This level is targeted by many analysts, including me, as a potential inflection point for the market.
Another example of the building technical resistance is the current overbought market indication being signaled by the Relative Strength Indicator (RSI) Index. As of Thursday, the short-term RSI reading for the SPX had crested back above the 70 level, a signal that stock prices have likely overextended their run. For reference, the chart below identifies the last four times the SPX’s RSI moved above 70, three of which triggered sharp short-term reversals as the market corrected from these overbought conditions.
Finally, from a sentiment perspective, this week’s Investor’s Intelligence report showed that the percentage of bullish newsletter publishers had moved to 54.8%. For those unfamiliar with the poll, bullish readings that approach 60% are often a sign that the “crowd” has become complacent or too optimistic, a telltale sign that stocks are likely to crest in the near future. The last time the Investor’s Intelligence poll saw these conditions was during the first quarter of 2011 — clearly a good time to be selling stocks.
So, assuming you’re convinced that the market’s current situation may soon reverse as the bears take control, the burning questions is: “How can you profit from a market pullback?”
Aggressive traders will have a list of stocks to short and put options to buy, but how about something for investors who like to keep it simple?
How about a few exchange-traded funds (ETFs) that will go up as the market corrects? Here are three that will provide your portfolio with an easy hedge:
ProShares UltraShort Financials (NYSE:SKF): The financial sector is one of the “worst-to-first” stories of the year as companies such as Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS) and Citigroup (NYSE:C) have all rebounded from their 2011 status as dogs of the market. While that’s all well and good, these companies face even more overhead resistance from their respective charts (200-day moving averages on all three companies are currently in-play) than the market.
Traders have been quick to pump these stocks higher on hopes that a deal in Greece would ease the fear that these banks would suffer losses from their ties to the EU. Unfortunately, that risk is not likely to go away until after the March 20 bond payments have been cashed. Until then, betting on the financial sector is like betting on a roulette wheel that won’t stop spinning.
Remembering that what goes up fast usually comes down fast, SKF lets you profit from a decline in the financials since SKF goes up roughly 2% for every 1% decline in the SPDR Select Sector Fund Financial ETF (NYSE:XLF).
The ProShares Short S&P500 (NYSE:SH) is a less targeted approach to profiting from a declining market, by simply buying an ETF that hedges the activity of a benchmark index — in this case, the S&P 500.
SH moves inversely to the S&P 500 at a one-to-one ratio, meaning the ETF will go up 1% for every 1% decline in the S&P 500. This less aggressive approach to trading a lofty market may not yield the fast and fat profits of a double-leveraged ETF like the SKF, but think about it: If you trim your portfolio positions and add this ETF, you are avoiding losses on existing positions and profiting from the decline. Money managers make very nice livings with this approach.
Of the three approaches, the iPath S&P 500 VIX Short-Term Futures (NYSE:VXX) is the most creative — and my favorite. Traders’ knee-jerk reaction when hearing the word “volatility” is to cringe. But VXX turns volatility into a trader’s friend as it, in essence, allows you to go long the volatility trade. That’s right — a term often used by elite traders, “going long volatility,” can now be achieved by buying a simple ETF instead of through complex options or futures contracts.
VXX rises as the CBOE Volatility Index, aka the VIX, values increase. This means the shares go up as the market goes down. Those well-versed in the ways of the VIX know that it tends to spike sharply when the market moves lower. For example, the VIX doubled in value in early August when the S&P 500 dropped by more than 15%. During that same time period, shares of VXX went up roughly 67%.
By purchasing the VXX shares, you can hedge a pullback in the market by profiting from the increase in volatility that is certain to occur. There is one catch: The VIX, and the VXX shares, tend to spike quickly, followed by a sharp decline. In other words, this position can produce profits quickly and then return to lower prices almost as quickly. Remember what I said about the financials — “what goes up fast usually comes down fast.” For this reason, a position in VXX is for the trader who is ready to watch the screen and act fast, but it sure can be fun profiting from volatility.