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The markets are scary, right? Gut-wrenching, even. They take rallies that look strong at midday and wipe them out by market close.
It's the one thing that investors at all levels are feeling and can agree upon.
But it doesn't have to be.
There's one simple strategy you can add to your investing game plan that will "smooth out" the worst of the coronavirus-pandemic volatility and ease the impact of the big sell-offs that could still come our way.
It's your single most powerful tool to protect against the one thing we have right now: uncertainty.
It's called "hedging," and the way I'm proposing to do this is so simple that anyone can do it - even my 75-year-old mom.
Hedging Doesn't Have to Be a Scary Word
I'll be candid with you all: I've been doing this - investing and trading professionally - for 30 years, and I've never seen anything like this before.
That said, I'm all about action - about taking control of your own destiny. As a trader, my instinct is to turn volatility into profits. As an investor, my instinct is to look for bargains that will pay off in the long run.
In both cases, my instinct is to find ways to reduce risk - to minimize the damage.
And hedging risk is a great way to do that.
When I started in this business, the concept of "hedging" was reserved for the ultra-elite investment professionals. The idea that you could at least partly "insulate" your portfolio from wild drops or even a bear market was farfetched and reserved for those who paid enormous fees to their money managers.
The idea of a hedge is simple. Offset some or all the risk in your portfolio when the outlook is uncertain, market volatility is on the rise, and the stock market faces its greatest risk.
When executed correctly, a good hedge will do two things. It will:
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- 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.
Best of all: This is something that investors of any experience level can do in the world of investing.
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.
Investors who've been around as long as I have remember doing most of their investing either directly through stocks, or through conventional mutual funds.
But ETFs represented a big step forward. First and foremost, they're simpler: You can buy and sell them just like stocks, a fact that simplified the process.
In 1993, the ETF known as the "SPY" was launched. This ETF allowed investors to do one simple thing: Buy the Standard & Poor's 500 Index - and benefit from its long-term gains - with a single, simple purchase.
That ETF truly revolutionized investing. And it was just the start. Today, there are more than 5,000 ETFs available. And they allow you to do all sorts of things - invest in domestic and international stock indexes, focus on specific sectors, invest in key themes, and benefit from different asset classes.
They also allow you to hedge your portfolio when the markets turn "mean."
And the "instrument" we're going to do this with is called the "Inverse ETF."
Introduced to the market in 2006, this ETF does just what its name implies - it moves opposite 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 times (2X) or three times (3X) 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.
Here are two examples...
Hedging Made Simple
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 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 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.
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.
And that's what we're here to help you do.
And in the meantime, be sure to check out my latest webinar…
You see, the market is going to fall. It’s going to fall hard. And it’s going to keep falling until September.
It’s a bold prediction… but today, I’m showing you why you don’t need to be scared of what’s coming. You just need to understand it, and you’ll have a chance to make a lot of money. I’m laying out the facts right here…
About the Author
Chris Johnson is a highly regarded equity and options analyst who has spent much of his nearly 30-year market career designing and interpreting complex models to help investment firms transform millions of data points into impressive gains for clients.
At heart Chris is a quant - like the "rocket scientists" of investing - with a specialty in applying advanced mathematics like stochastic calculus, linear algebra, differential equations, and statistics to Wall Street's data-rich environment.
He began building his proprietary models in 1998, analyzing about 2,000 records per day. Today, that database, which Chris designed and coded from scratch, analyzes a staggering 700,000 records per day. It's the secret behind his track record.
Chris holds degrees in finance, statistics, and accounting. He worked as a licensed broker for 11 years before taking on the role of Director of Quantitative Analysis at a big-name equity and options research firm for eight years. He recently served as Director of Research of a Cleveland-based investment firm responsible for hundreds of millions in AUM. He is also the Founder/CIO of ETF Advisory Research Partners since 2007, noted for its groundbreaking work in Behavioral Valuation systems. Their research is widely read by leaders in the RIA business.
Chris is ranked in the top 99.3% of financial bloggers and top 98.6% of overall experts by TipRanks, the track record registry of financial analysts dating back to January 2009.
He is a frequent commentator on financial markets for CNBC, Fox, Bloomberg TV, and CBS Radio and has been featured in Barron's, USA Today, Newsweek, and The Wall Street Journal, and numerous books.
Today, Chris is the editor of Night Trader and Penny Hawk. He also contributes to Money Morning as the Quant Analysis Specialist.