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When the markets are down like they have been in 2014, it's smart to know how to protect your money from a stock market crash.
While other investors worry about the markets tumbling further, you can start protecting yourself from a potential stock market crash.
Here are three strategies to prepare today.
Protecting from a Stock Market Crash: Inverse Index Funds
Inverse exchange-traded funds are designed to perform in the exact opposite of the index they are tracking. Trading inverse index funds can be one of your best hedges against a sharp market decline.
For instance, the ProShares Short S&P 500 (NYSE: SH) will post the inverse results of the S&P 500. In January, the S&P 500 posted a loss of 3.6%. Accordingly, SH was up 3.5% in that month.
Investors who were bearish on the S&P 500 could have purchased shares in the ProShares Short S&P 500 in January and offset some of the losses they experienced elsewhere with that 3.5% gain.
Protecting from a Stock Market Crash: Put Options
Buying protective put options is another strategy for investors anticipating a market crash.
When investors buy put options, they are signing contracts giving them control over 100 shares of a stock. An investor will buy a put option when he or she expects the value of a stock to decrease.
Every option has an expiration date, which is the third Saturday of the expiration month chosen. Once the expiration date passes, the option is terminated.
With a put option, the investor buys the right (but not obligation) to sell 100 shares of a stock before the expiration date. The more the share price depreciates compared to the initial purchase price, the more valuable the put option becomes.
Here's how it works:
Say an investor wants to insure a stock he holds against a market drop. He can buy a put option that gives him the right to sell shares of the stock at a certain value, or "strike price."
Once the value of the stock dips below the strike price, the investor is "in the money" - meaning the position is profitable, and the option contract itself is worth something. The investor can do a couple of things.
First, he could sell the put option contract - which will be valuable because it's in the money. An investor can do this when expecting the long-term price of the stock to rise, but he wants to make some money while broader markets are slipping.
Or the investor can exercise the option to sell the shares at the strike price. The investor's profit will be the sale, minus the cost to establish the initial position and the cost of the put option.
An investor doesn't have to own the underlying security to profit from put options. If the share price has fallen below the strike price, the investor can purchase shares of the stock for that low price. Then he will sell them at the strike price and pocket the profit (minus the cost of the put option).
There are risks investors must note before using put options. If the investor makes the wrong decision and the stock appreciates in value by the time the put expires, he will be left having to pay the difference.
There are numerous strategies for using put options, and they can be extremely valuable when used correctly. Read more about using options to protect your portfolio.
Protecting from a Stock Market Crash: Trading the VIX
The Volatility S&P 500 Index (INDEXCBOE: VIX) or VIX is often referred to as the "Fear Index," because it provides an inside look into what investors are thinking about the market.
The common misconception is that the VIX only tracks the volatility of the S&P 500, as its name suggests. However, the indicator actually tracks options trading on the S&P 500.
If the volume of call options is up, investors are bullish on the S&P. Conversely, when the volume on put options is high, investors are bearish.
The VIX tends to have an inverse relationship with the S&P 500. For instance, the VIX was up 34% in January 2014 when the S&P was down 3.6%. The 34% gain means that there was a high volume of put options being purchased.
Money Morning Capital Wave Strategist Shah Gilani has been trading the VIX for years - sometimes delivering triple-digit gains in days for his subscribers. He explains how to trade the VIX like the pros here.
Do you think the selloff has just begun, or are you expecting the markets to turn around? Let us know on Twitter @moneymorning by using #StockMarketCrash.
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