Let me paint you a picture: Imagine your house, safe and sound. You want to insure it, so you buy a policy and pay regular premiums on it. Of course, if the unthinkable happens, you’re covered.
Now imagine you’ve got no policy, and, one day, your house is starts to burn… You desperately call Allstate or Metlife to find that a policy is getting way more expensive with each passing second (though, I’m pretty sure no insurance company would write a policy under those circumstances).
Then when the “fire” starts, they’re either paying through the nose… or going without.
In fact, this very subject came up just the other day on my Markets Live stream, and by the time we were through with the session, we were all a lot smarter – and better protected.
And the timing is good: The next leg down may have already just started…
Get Ready: It’s “Fire Season” in the Markets
It seems like a million years ago now, but remember 2017? It was the least volatile year on the markets in decades. That November, the VIX bottomed out at 9.14; that sounds unbelievable right now, but it did.
But today, in the middle of a global pandemic, all the economic carnage that’s happened, and an earnings season like no other… volatility’s riding tall in the saddle and could be for months, even years, to come.
Now, I always say, “Volatility is a trader’s best friend.” It’s Commandment No. 7 of my 10 Trading Commandments. Market panics create the big price swings that yield life-changing trading profits.
When the VIX is below 25, calm prevails, and trend reversals are unlikely; when the VIX spikes, though… opportunity knocks.
But my eagerness for big moves doesn’t mean I go unprotected against the “fire” of downside risk. If anything, it makes hedging more important.
Hedging is a really simple, powerful technique that protects your capital from the uncertainty that comes along with that volatility and leaves you free to go after big, big profits.
Very simply put, a hedge is some investment or trade that’s going to put cash in your pocket when markets start going down.
When executed correctly, a good hedge will do two things. It will:
- Protect your overall net worth by gaining in value when your other holdings fall.
- And, in effect, generate additional cash that you can turn around and invest when stocks are way down.
It used to be that trading was the best way to do this, but nowadays, with inverse and inverse leveraged exchange-traded funds, it can be as simple as buying a stock.
And this is where investors can get a little leery; it’s that question I mentioned that came up in my live session the other day.
I’d recommended a hedge – I’ll share it with you in just a few here, because I still like it – and the position… lost money. It did so for several days, in fact, though the losses were small and regular.
What’s more, they weren’t unexpected. Still, a lot of folks were getting nervous holding the position and let me know it.
I’ll tell you what I told them: Hold on. Small losses are okay. If you sell the position and markets start to decline, it’ll only be more expensive to get back in. If you have to give up 5% or even 10%, at the top or bottom of a move, so be it.
Investors have to get into the mindset that hedges are like portfolio insurance, and like any insurance, you pay for it. Not a lot, but you do have to fork over premiums to hold the policy.
Holding a hedge is no different. It costs a little, but – boy, oh boy – will you be grateful to have it when you need it.
It’s Never Been Easier to Hedge
In today’s stock market, even everyday retail investors have a bevy of hedging tools at their disposal. But today, I want to focus on one of the simplest – the “exchange-traded fund,” or ETF.
Specifically, inverse ETFs.
Introduced to the market in 2006, this ETF does just what its name implies – it moves inversely to the investment the fund represents. If it’s the S&P 500, it goes up when the index goes down – and by the same magnitude.
As ETFs have become more sophisticated, we’ve even seen “leveraged” inverse ETFs – which move two or three times the magnitude of the underlying investment, and in the opposite direction.
Like the rest of the ETF universe, inverse ETFs have exploded in popularity, but a few of the simplest of them can help you now.
ProShares Short S&P 500 ETF
The simplest of the inverse ETFs, the ProShares Short S&P 500 ETF (NYSEArca: SH), does one simple thing: It largely mirrors the performance of the S&P 500 – but in the opposite direction. In other words, if the S&P 500 declines by 1% in a day, the SH shares will appreciate by about 1% (and vice versa).
This makes hedging a portion of your portfolio a very straightforward endeavor. Every dollar that you invest in the SH shares should come close to offsetting each dollar lost in a portfolio invested in S&P 500 holdings.
This makes the SH shares a good alternative for those of us that hold stocks, mutual funds, or ETFs that benchmark against the broad market index.
Here’s a scenario.
Had an investor split a $20,000 portfolio between the SPY and SH shares at the beginning of the year, their portfolio would currently be worth $19,652. A $20,000 portfolio that was unhedged and only invested in the SPY shares would be worth $15,422.
The simple hedge protected against losses of $4,230.
But the story is actually even more interesting. By turning around and selling the SH shares while the market is down, you now generate almost $12,000 in cash – which could then be invested in stocks while the market is at a 19% discount.
So, let’s let this play out a bit more and assume that stocks eventually return to their price levels of Dec. 31, 2019. If this later plays out, our “test portfolio” would now be worth $25,485 – thanks to the benefit reaped after taking your SH proceeds and using the money to buy SPY shares again.
Without the hedge, the portfolio simply returns to its original value of $20,000. You just made an extra $5,485 – or an additional 27%. That additional performance is what investment pros refer to as “alpha,” and it’s the Holy Grail for investors who make their living investing OPM (other people’s money).
There’s another, shall we say, “less tangible” benefit, too.
And it’s a big one.
By hedging, you didn’t have to sit around, drink antacid, and chew your nails like all your friends are doing – because you’ve got a hedge working for you.
Here’s another example using a hedge and cash.
ProShares UltraShort S&P 500
We mentioned “leveraged ETFs.” And, indeed, another Proshares offering provides the same hedge against the S&P 500, but leveraged. So instead of gaining 1% when the S&P 500 falls 1% – in a step-for-step fashion, like the SH shares – the ProShares UltraShort S&P 500 (NYSEArca: SDS) ETF is leveraged to provide a 2% gain.
In practice, this means that you can use less money from your portfolio to gain the same protective edge over the markets. This also means that you can free up cash for later purchases when the market is trading significantly lower.
We call this “dry powder money.”
Using the same portfolio of $20,000, you could hold your $10,000 investment in the S&P 500, put $5,000 in cash, and then purchase $5,000 of the SDS shares. Here’s how that would have played out as of Friday, April 3.
Your total balance on April 3 would have been $19,248, which includes $5,000 in cash you’d have to start putting to work in sell-off “bargains.” Plus, you can sell your hedge for another $6,537 in cash to put to work when the market is trading almost 20% lower. The hedge resulted in more buying power at the bottom. This is how the top pros work.
Once again, let’s assume that you sell the hedge at a value of $6,537, and with your cash reserves, you’ve got $11,537 to invest back into the S&P 500 ETF (NYSEArca: SPY).
When the S&P 500 crosses back above its Dec. 31, 2020, price level, your portfolio will be worth $24,961.37. Compare that to the unhedged portfolio, which would be worth just $20,000.
That’s “alpha” of 24.8%.
And remember, you had $5,000 sitting “comfortably” in cash – the whole way down.
When was the last time an insurance policy paid almost 25% more?
Now that’s the right kind of premium!
The bottom line here is that there are ways to more smoothly navigate these mean markets – in ways that reduce your downside, boost your long-term upside, and just leave you feeling more secure even at the market’s darkest moments.
— Chris Johnson
Source: Money Morning