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Hedging Your Bets Against a Potential Correction

As the market continues to post new all-time highs day after day, it’s natural that investors would begin to feel skeptical about remaining fully invested in long positions going into the new year. The major indices have all appreciated by more than 25% in 2013, so it’s no wonder why traders with a lot of green on their screens are anxious to sell and lock in profits while the getting’s good.

However, there is another way to protect your hard-earned capital gains without unloaded all of your holdings. I’ve written previously about how traders can use leveraged inverse exchange traded funds (ETFs) to hedge a portfolio against the risk of a market pullback or correction, but I continue to get questions about how to choose the right hedge for a number of different market scenarios.

Beware of Leveraged ETFs

One of the biggest concerns I’ve been asking about regarding leveraged inverse ETFs is that the daily rebalancing of the funds makes them ineffective as part of a long-term hedging strategy. Many leveraged inverse funds can return  one, two or three times the inverse return of a particular index on a given day, but may return a loss if held for too long.

For example, let’s say you purchase one share of the ProShares UltraShort S&P 500 (SDS) for $30 while the S&P 500 is at 1,800. If the index hypothetically fell 100 points to 1,700 in one day — a loss of 5.56% — the SDS would gain 11.12% and would now be valued at $33.34. However, if the S&P moves back up to 1,800 the following day — a gain of 5.88% — the SDS would lose 11.76% and would now be valued at $29.42, and you’d be stuck with a loss of 1.93%.

With that said, if I thought a correction was going to be lasting, I’d be more inclined to maintain a position in the leveraged ETF in an effort to raise cash and then exit the ETF once the main portfolio was repositioned in sync with the investing environment at hand.

I’m also open to working with unleveraged ETFs as well, such as ProShares Short S&P 500 ETF (SH), ProShares Short Dow 30 ETF (DOG) and, for the Nasdaq, ProShares Short QQQ ETF (PSQ).

Hedging in a Rising Rate Environment

As the yield on the 10-Year Treasury note pushes back up to the 3.00% level, many of my subscribers have written in to ask how they should best protect their interest rate sensitive assets in the case of a market correction. More specifically, I was recently asked if I would ever recommend a short bond ETF as a portfolio hedge.

The easy answer is yes. However, in the current market landscape, you want to be careful not to short what’s considered to be a safe haven. Keep in mind that investment-grade bonds typically rally in the event of a sharp downturn in equity markets, so you would want to stay away from short investment-grade bond ETFs if you’re counting on a correction.

On the other hand, you might want to short a levered high-yield junk bond fund as an alternative. During market pullbacks, investors tend to rotate out of junk bonds because their yields no longer justify the increased risk of a default. Junk bonds generally carry higher yields to make themselves more attractive to investors, but as yields on investment-grade bonds rise, money tends to move into those bonds that offer both high yields and increased security.

Bryan Perry is the editor of Cash Machine, a newsletter focused on high-yield income investing with the goal of maintaining a blended total yield of 10% across two portfolios. Bryan is also the editor of Extreme Income which uses the power of historically cheap money to create a leveraged “baby hedge fund” strategy that paves the way to massive profits and 4x greater income.

Stay tuned! Bryan is currently working hard on a brand new strategy that amplifies income potential by utilizing a conservative options strategy based on stocks you may already own.

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