My Absolute Favorite Way to Protect a Portfolio

By David Sterman,

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The steady market gains we've seen during the past four months have made me a bit nervous. All of the action seemed to be benefiting the riskier plays in the market, leaving seemingly safer plays one step behind. As a result, a focus on stocks with strong downside support has not been the place to be, hampering relative returns in my $100,000 Real-Money Portfolio . In effect, I've been buying a group of tortoises, while the hares have been the ones winning the race lately.

But it's a long race, so I'm not deterred.

A market that quickly changes direction won't just punish the riskier stocks that have been in vogue; it will also drag down virtually every stock in tandem. That's what we saw this week when the Dow Jones Industrial Average posted its first 200 point drop of 2012 on Tuesday, March 6.

Thankfully, a few days before I loaded up on the Direxion Small CapBear 3XShares (NYSE: TZA ) . this bearish exchange-traded fund ( ETF ) rose 6% on the day the market plunged. And because I'm convinced that small-cap stocks are especially vulnerable right now, I'm holding on to this fund, despite the fact that it has risen 15% in just nine trading sessions.

Just ahedge -- that's it
Where will the market go from here? If I could answer this question, then I wouldn't even bother buying stocks. Instead, I would buy this kind of leveraged ETF, which magnifies a sector, industry or market by moving at twice or three times the rate (or, in some cases, in the opposite direction) of whatever it is tracking. (In the case of my portfolio holding, TZA, it moves at three times the rate in the opposite direction of the Russell 2000 Small Cap Index .)

No one has a crystal ball. That's why it's best to focus on the best stock ideas that can outperform the indexes. Yet a growing case can be made for the use of these enhanced ETFs (also known as leveraged-ETFs or geared-ETFs), simply because most investors tend to build portfolios around long positions, and few investors tend to balance them out with short positions, essentially creating a "market-neutral" portfolio.

With more than 80% of my $100,000 Real-Money Portfolio committed to long holdings, using an enhanced ETF as a hedge made ample sense. Of course, if the market starts to rally to fresh highs, then this hedge will inflict some pain. On the other hand, if that happens, at least the rest of my portfolio would rise in tandem with the market.

There is a time and place to use these enhanced ETFs as a direct play, and not just a hedge. If you see a clear macro event that will affect a sector or industry, then it may be unclear which company will derive the greatest profits or losses from that trend. In that case, an enhanced ETF saves you the trouble of analyzing individual stocks and allows you to move quickly before the market spots the macro issue.

For example, let's say you think natural gas prices are about to rally. The quickest way to capitalize on the move would be to buy the Direxion Daily Natural Gas RelatedBull 3X Shares (Nasdaq: GASL ) .

Here's a quick look at the most popular enhanced ETFs, and the role they serve...

Risks to Consider: These ETFs typically carry an expense ratio of at least 0.5%, so if you buy them for a very short holding period , then those fees and the bid/ask spreads may eat into your returns.

Action to Take --> It's understandable why many investors avoid short-selling. It's a wild corner of the market, as seen by occasional, powerful short squeezes. These enhanced ETFs can provide similar forms of hedging without the risk of a short squeeze .

[ Note: You can also follow along with my $100,000 Real-Money Portfolio trades free for a limited time. Simply click on this link to sign up .]

-- David Sterman

David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC owns shares of TZA in one or more if its "real money" portfolios.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

© Copyright 2001-2010 StreetAuthority, LLC. All Rights Reserved.

This article appears in: Investing ETFs
Referenced Stocks: ETF , GASL , TZA

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