4 Ways to Hedge Against a Stock Market Correction

With recent highs going ever higher, there are several strategies for advisors and clients to consider

Is the S&P 500 breaking above previous all-time highs--1,565 reached on Oct 9, 2007--the beginning of more good things to come for stocks? Or is it time to lighten up?

The S&P 500 is now running an incredible streak of 546 consecutive calendar days without a 10% correction.

To put that in perspective, the current pace is close to breaking a 56-year record of 650 days, which took place from Oct. 22, 1957 to Aug. 2, 1959. Put another way, the longer the market goes without a correction, the more severe the correction will be when it finally does arrive.

Fund manager John Hussman gives rather excellent guidelines on what is the maximum drawdown or losses an investor should bear:

“An intolerable loss, in my view, is one that requires a heroic recovery simply to break even,” Hussman explained. “A short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).”

Keeping Hussman’s rule of thumb in mind, let’s examine a few strategies for hedging against a correction in stocks. 

1.   Inverse ETFs

Inverse-equity ETFs are built to increase in value when stock prices fall. Although they are not meant to be bought and forgotten, but can offer temporary shelter in a market decline.

The current generation of inverse or “short” ETFs has daily objectives of either 100% opposite performance, or in the case of leveraged funds, 200% or 300% opposite returns.

For advisors that want a simple short-term hedge, most of the 100%-opposite or negative-one-times ETFs should get the job done. ProShares and DirexionShares offer inverse-equity ETFs on large-, mid-, and small-cap stocks with and without leverage. 

2.   Put Options

Buying protective insurance via put options on stock ETFs is another way for minimizing the damage of falling stock prices. Put options are designed to increase in value when the underlying asset or ETF falls in price. In other words, any losses in the value of stock ETFs, would be offset by gains in the underlying put options.

Put options act in a non-linear fashion. That means it requires a small dollar amount of them to hedge a much larger dollar value position in an underlying security.

Most heavily traded stocks ETFs like the SPDR S&P 500 ETF (SPY), Vanguard FTSE Emerging Markets ETF (VWO) and iShares MSCI EAFE ETF (EFA) have underlying put options trading on them.

The length of insurance coverage via put options can be as short as one month or up to a year, depending on when the options contracts expire. In other words, advisors can customize the length of insurance with options to match their client’s unique needs.

3. Buying Volatility

Higher stock prices have led to depressed market volatility.

In 2012, the CBOE S&P500 Volatility Index (VIX) had an average daily closing value of just 17.80, but today the VIX has fallen even lower to the 12-13 range.

That puts the VIX right at pre-credit crisis levels seen in 2005-06. What does this mean?

A depressed VIX can be interpreted as too much complacency or lack of fear in the market. It’s frequently used as contrarian sell signal.

Conversely, an elevated VIX infers a high level of fear and could be a good buy setup, depending on the circumstances. One way to hedge against lower stock prices is to buy purchasing call options on the VIX.

Premiums have become inexpensive and offer a good way to hedge. Unlike VIX ETPs, which don’t allow advisors to customize the length of their trade to a particular month, VIX call options can be bought for one-month into the future or several months. The VIX is inversely correlated with the S&P 500. The VIX is quoted in percentage points and measures the expected movement in the S&P 500 over the next 30 days.

4. A Cash Cushion

The average yield on 7-day retail money market mutual funds is a paltry 0.05%.

At that rate, it would take a person 1,440 years to double their money! No wonder so many people, and even some advisors, believe that “cash is trash.”

But during a market downturn, cash isn’t trash.

Ever notice how Warren Buffett’s Berkshire Hathaway always has a multi-billion dollar cash cushion? That’s because when the stock market gets roughed up, cash in a portfolio gives the owner financial flexibility.

Cash is the easiest way to hedge against a downturn and gives advisors the luxury to buy assets on the cheap, when the crowd is running for the exit signs.

It’s called opportunistic investing.

And it’s just one more way to hedge against a market correction.

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