To date, this year has been the worst ever in terms of starts for equities, as spiraling crude oil prices and concerns over economic conditions in China are rippling through the markets. The bottom line is that many investors are preparing for the first bear market in more than seven years, with good reason.
Currently, our short-term market models are forecasting a 4-6% dead cat bounce in the market as stocks and sectors have reached extremely oversold readings on a number of indicators.
It’s what comes after that rally that concerns us, as overhead technical resistance and questionable fundamentals signal that the S&P 500 is in its first bear market in more than seven years.
As is usually the case, higher beta sectors like small cap, biotechnology and some technology are feeling the burn, while consumer staples, utility and REITs are getting a bid. The action indicates that investors are seeking some sort of safe harbor from the storm.
While these strategies may reduce losses, they do little to actually hedge an account from further declines.
A hedge is defined by Investopedia as “an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.”
While most think that hedges are complicated, the truth is that they are easy enough that any investor should consider the strategy as volatility continues to rise. Here are three varying levels of hedged investments that will help prepare your portfolio for the next 10% decline.
Bear Market Funds: ProShares Short S&P500 (ETF) (SH)
One of the oldest inverse exchange-traded funds, the ProShares Short S&P 500 ETF (SH) shares provide a way to profit when the S&P 500 declines. The SH shares appreciate by approximately a percent for every decline of the same amount.
The simplest way to use the SH shares is to determine a percentage of your portfolio that you would like to hedge (say 25%) then allocate that amount to buying SH shares in the market (currently trading at $22.75).
If the S&P 500 drops 20% while holding this hedge you will be able to sell the shares for about 28.50 and invest the proceeds back into your portfolio with more money at lower prices. That’s how the pros do it!
Bear Market Funds: ProShares UltraShort S&P500 (ETF) (SDS)
The Ultrashort S&P 500 ETF (SDS) gives a little “oomph” above the regular Short S&P 500 ETF by adding some leverage to the strategy.
As a result, SDS shares increase in value approximately 2% for every 1% drop in the S&P 500. The added leverage means that you can allocate less to hedge more of your portfolio. Of course it comes with a cost.
The leverage of the SDS shares can work against investors if the S&P unexpectedly rallies since the shares will decline twice as fast as the S&P 500 rallies. This means that managing the hedge is a little more important.
With double the leverage, you can allocate less to the hedge and get the job done with SDS shares, making it one of our favorites for volatile markets.
Bear Market Funds: iPath S&P 500 VIX Short Term Futures TM ETN (VXX)
We hear the term “hedging volatility” referred to as a strategy that portfolio managers use to protect their holdings. Years ago, this was done through the use of options and futures on the CBOE Volatility Index (commonly referred to as the “Fear Index”). Now, even the pros have it simpler by using VXX.
There are some drawbacks to VXX, however, that make it more of a short-term hedging tool.
First, the portfolios of futures that the fund holds have time decay values, which means that the price of VXX shares over time will have “slippage.” The same slippage also means that the VXX shares may not appreciate as fast as the VIX.
That said, the VIX tends to move at breakneck speeds when volatility does hit the market, making it a useful tool for short-term hedging.
For example, the recent decline in the S&P 500 resulted in a 50% move in the VXX. For the nimble trader, the VXX is a very attractive alternative.
As of this writing, Johnson Research Group did not hold a position in any of the aforementioned securities.
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