Investors who feel the stock market is either overvalued or skating on thin ice and concerned that there could still be another shoe to fall, should consider taking some action to protect against portfolio loses.
There are two primary strategies you can take.
The first and most obvious is to get out of the market and purchase short-term treasury bills that are equivalent to cash. This would be the most conservative approach and would simply give up all upside potential the may exist.
The second strategy may not be so obvious, but should at least be considered by many investors, especially if your investment strategy is to produce current income from dividend mutual funds or dividend paying stocks. If your trading stock on line or through a broker, you have the same ability to "hedge" or protect your investments as anyone else.
There are several strategies an investor can employ to hedge against downside risk. The five most common are as follows:
1. Short ETF (Exchange Traded Fund) - The main advantage is these vehicles are easy to buy and sell and provide direct inverse correlation to the index you are selling against. As with most hedging strategies, you will limit some upside potential if the market proves you wrong, which can happen by the way.
2. Sell Covered Calls - This will produce current income for your portfolio of stocks or exchange traded funds in a flat or slightly down market, but if there is a real bear market, fast and fierce, you are limited in your hedge and are not protecting against a major decline.
3. Buy Puts on your stocks or exchange traded funds - This strategy will protect against a major market decline that impacts your holdings, but the problem is that your timing must be relatively accurate. Now you're really trying to time the market, and this is usually a fools game.
4. Sell Short the major index like the DOW, S&P or Nasdaq - This will protect against a broad market decline. You are limiting your upside potential and in order to employ this strategy, you much have margin available in your account to sell short. You are also responsible for any dividends the securities you sell short pay.
5. Sell naked calls on an index - In a flat to slightly down market, you will do fine, but you limit any upside participation that occurs. Your downside protection is limited to the amount of premium you take in by selling the calls, and if the market takes off, you can lose big. This is not for most investors, and would require additional paperwork with your broker that outlines the risks involved. (Don't do this)
The strategy I like the best for the majority of investors is the first one, purchasing a short ETF. An example of this would be an exchange traded fund like SH that is in direct opposite correlation to the S&P Index Fund SPY, and also the S&P 500 Index.
If you time horizon is relatively short in terms of your desire to hedge market risk, then this approach should suit you just fine. Let's say you have a portfolio of $1,000,000 that is producing on average 5% income from dividends. Since it's a tough call to liquidate everything, potentially pay capital gains if you have them, and walk away from $50,000 of income. One alternative is to keep the dividend paying stocks or dividend mutual funds in place and purchase the inverse index fund (SH) in an amount you are comfortable with. Now, you must understand with this strategy, unless you are buying an equal amount of the inverse fund to what you have invested in the market, you most likely will not be able to protect 100% of the downside risk. However, protecting some is better than none. The amount is completely up to you and will be based on how much cash you are willing to put forth or how much you wish to go into margin (NOT recommended).
Of course, you can always combine any of the strategies outlined above to achieve your goal. A combination of selling higher volatile stocks and purchasing some of the inverse fund will work for most in these uncertain times.
Any strategy outlined above is for informational purposes only and you should consult a professional before making any decisions. You can lose money by implementing a hedging strategy if you don't know what you're doing. In fact you can lose money even if you do know what you are doing.
Invest with Vigilance.
David Frost is the founder and an analyst for Strategic Forecasting. They provide market forecasts for subscribers in the United States and throughout the world. For more great tips on the Stock Market, hedging or other financial related topics please visit http://www.MyStrategicForecast.com/
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