Chances are you likely had a successful year in thestock market
Despite all the gloom and doom ranging from "Fiscal Cliff" fears
to the threat of a globalrecession , your portfolio has probably
weathered the storm, showing solid profits for 2012. On average,
the S&P 500 gained about 15% last year, as you can
see in the chart below...
However, theeconomy is not out of the danger zone yet. There is
still much uncertainty about the rest of the world's economic
This fact forces the question: Should you take profits now or
keep holding withspeculation the upward momentumwill continue?
This is quite a dilemma for investors sitting on a profitable
portfolio. You don't want to see your profits wither away, but you
also don't want give up on additionalupside by booking
Fortunately, there is a solution to this quandary. It's
Hedging is the opening of positions in the opposite direction of
the portfolio to protect yourinvestments fromdownside risk , while
keeping the potential for additional upside.
Hedging was once the province of only institutions and very
sophisticated investors who would buy options andfutures tohedge
against their current holdings. But trading options and futures
requires precise timing, special future and options accounts, and
involves its own high-risk factors.
This is where exchange-tradedfunds (
) come in. ETFs provide average investors like you and me with the
right tools to protect our portfolio from heavy downside risk. It
is no longer a must to open a risky futures or options account to
hedge your portfolio. ETFs can easily be traded within your regular
stock account without the hassle of using differentbrokers and
No free lunch
Unfortunately, there is no free lunch in the stock market. Hedging
with ETFs is similar to an insurance policy. It is designed to
protect your portfolio from a downside, but at a cost. A good way
to look at this is to remember that when you buy an insurance
policy, although it comes at a cost, the policy will protect you
should the unexpected happen.
The cost of hedging with ETFs makes up some of the cost of
the ETF , as it will not "expire" worthless like anoption
would and give up on maximum possible upside should things continue
profitably in your portfolio.
How to do it
The wide variety of ETFs allow you to hedge different portions of
your portfolio depending on which you believe is most at risk at
Let's say your portfolio is heavilyweighted with Nasdaqstocks
and you believe the technology sector may suffer a sell off during
the upcomingearnings season . You could then short the
, which tracks theNasdaq 100 Index .
Similarly, if you believe the total market may be heading
sharply lower, then shorting the
could create a hedge for your entire sector-diversified
Your time frame is critical
There are also inverse and leveraged ETFs, such as
, that can provide short-term hedges for specific events. This
inverse ETF corresponds to twice the opposite of the
daily performance of the S&P 500.
An example would be if you believe a critical economic release
would result in a sharp negative reaction in your portfolio. You
could then purchase the inverse ETFs to hold just before and after
the event. Leveraged ETFs are simply too volatile and uncertain to
hold for the long term. However, they make a fine choice for
protecting against specific daily events.
Risks To Consider:
Hedging your portfolio with ETFs comes with a cost. This cost
is a portion of the price paid for the ETFs and theopportunity cost
of buying the ETFs, rather thaninvesting the price paid directly
into your directional portfolio. However, the benefits could save
your portfolio should a sharp drop occur.
Action To Take -->
My rule of thumb for hedging with ETFs is 10%. This means is I
would short $10,000 worth of ETFs for every $100,000 valuation of
my portfolio. This number can change up or down, depending on how
strong my conviction is of any pending downside. However, 20% of
portfolio value is generally the upper limit to hedge against all
but the most extreme market drops.
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