Stocks

Hedging Strategies: Tight Trailing Stops and Inverse Funds

By , Money Morning • February 10, 2011

The Dow Jones Industrial Average has soared 26% since early July and some 84.59% from its March 2009 bear-market lows. And that has Money Morning Chief Investment Strategist Keith Fitz-Gerald more than a little concerned.

Does that mean it's time to cash out?

Not necessarily.

But it is time to take some well-advised precautions - which can be achieved with some simple hedging strategies, according to this market veteran who's seen it all before.

"Back in early July, the Dow was trading at less than 9,700 ... now that it's north of 12,000, we're climbing into thin air," Fitz-Gerald said in an interview. "Don't get me wrong. I'll take higher markets any day, because it means that all boats are floating on a rising tide. But I'm leery that there's a monster lurking underneath the surface. And you should be, too."

At this key juncture, Fitz-Gerald says that you need to make two key moves:

Tighten up on your "trailing stops."
And hedge your portfolio with a so-called "inverse fund" - specifically the Rydex Inverse S&P 500 Strategy Fund (RYURX).

Here's why: Although Fitz-Gerald acknowledges the fact that consumer confidence is on the rise, that industrial production and corporate earnings are improving, and that U.S. stock prices could easily continue to go up from here, he also says that he's "not sure that the worst is behind us."

"I am not suggesting the sky is falling," Fitz-Gerald said. "What I am saying is that we need to keep our eyes and ears open, even as we ride our holdings to new highs. And the way to do that is by tightening up on our protective trailing stops, and by using the inverse fund to protect our profits and cushion any downside move in the broad indices."

Trailing stops are a useful and potentially effective tool because they can be moved up as your stocks rise in price.

The Rydex fund is a specialized inverse fund that appreciates if the U.S. Standard & Poor's 500 Index falls for any reason. This is a strategy we deploy specifically to guard against unexpected declines that would otherwise devastate our upside potential and the above average income we try so hard to maintain at all times as part of our disciplined investment approach. Various studies suggest that 5% to 10% of overall assets can provide meaningful protection and significantly stabilize overall returns.

Actions to Take: U.S. stocks have run up a long way in a relatively short period of time. With the loose-money policies of the U.S. Federal Reserve, that run-up could well continue.
But investors need to take steps to protect themselves. Specifically speaking, investors need to:

Tighten up on their "trailing stops."
And hedge their portfolios by purchasing shares of the Rydex Inverse S&P 500 Strategy Fund( RYURX). Money Morning's Keith Fitz-Gerald advises investors to split "new" investment money into five equal chunks and begin buying the Rydex fund in installments over the next five months. Studies suggest that having about 5% of overall investable capital in non-correlated assets like the index fund will do the trick.

News and Related Story Links:

Money Morning Investment Strategies:
Investment Strategies For 2011: The Right Way to Use Inverse Funds.
Money Morning News:
World Money Show News: Money Morning's Keith Fitz-Gerald to Speak This Week at Orlando Investing Symposium