Anyone who owns stock knows this year has given us pain with no gain. Since its peak in October of 2007, the stock market has dropped by about 40 percent, and not even the oracles of finance can determine if we’ve seen the bottom yet.

There are different strategies to hedge your bets and reduce losses on a diversified stock portfolio or on an individual stock, depending on how bearish you are, and when you think the market will recover. None of these strategies is for the faint of heart, however, and you will need to invest time in making sure you understand them, or find a trusted adviser who can explain them to you, as well as execute them.

Definitions
  • Correlation — a statistical measure of how two securities move in relation to each other.
  • Leverage — Using borrowed funds, or debt, to increase equity returns.
  • Derivatives — financial instruments where the value comes from the underlying asset, which could include stocks, interest rates or currency exchange rates and real estate.
  • Options — A contract that gives a buyer the right, but not the obligation, to buy or sell a particular asset, like a stock.

Three strategies — negative correlation funds, protective puts and equity collar options — are all designed to reduce losses from short-term market volatility, or protect you from steep losses if you have a large position in a single stock.

The key to success is finding the right strategy to fit your personal risk profile, time horizon and the amount you are willing to pay for protection. And you must realize the gambles inherent in each strategy. You may reduce your market risk, but there will be other risk, like interest rate risk.

“In order to get reward, you have to take risk, but it has to be measured risk,” says Clare White, a chartered market technician and a technical analyst for Optionetics, an investment education and trading Web site. “It’s so important in this market to know how to protect your portfolio.”

Negative correlation ETFs

Investors who heeded the call to diversify into a portfolio of small cap, midcap, large cap, value, growth and international equities have seen a fairly uniform result over the past year. All have lost value.

Historically, when one or more of these asset classes was down, others were up, maintaining the portfolio on an even keel, or steadily gaining in value. But when the entire portfolio is trending downward, one of the easiest methods of hedging is to buy negative correlation exchange-traded funds, or ETFs, also called inverse funds, which are available from companies like Rydex, ProShares and Profunds.

These funds “short” the market, using a variety of strategies that mutual funds are not allowed to use, including leverage and derivative trading, depending on the specific fund.

When you own stocks in a mutual fund, you are considered to be “long,” so the short funds theoretically hedge your bet with alternative strategies in case the stocks in your long funds decrease in value.

“Since 2000, I’ve been calling the buy and hold strategy ‘buy and hope,'” says Moe Ansari, president and chief portfolio manager of Compak Asset Management in Irvine, Calif.

He advocates reducing those aspirational aspects of “buy and hope” by balancing portions of a long portfolio with short ETF funds. By looking at the areas of your portfolio that have become overweighted, say large-cap growth stocks, an investor can choose to hedge a portion of that particular asset class by buying a negative correlation fund for the corresponding index or sector, in this case the S&P 500. Negative correlation funds are also available for the Nasdaq, the Russell 2000, the Dow, as well as in various sectors like emerging markets. “It will not be a perfect hedge,” Ansari says, but he likens it to “having a brake and accelerator on your portfolio” because you’re controlling exposure to market risk to some extent.

Diversification is the best protection in a bear market, says Gary Goldberg, CEO of Gary Goldberg Financial Services in Suffern, N.Y. “We are bearish now,” he adds, so depending on the client’s risk tolerance and time horizon, they are putting a percentage of their portfolios in inverse funds.

Based on current price/earnings ratios, Goldberg says, the market is still in for “some powerful periods” of volatility, and investors should be looking to mitigate risk.

Advantages: These funds are best used to protect against short-term volatility.

The strategy is easier to implement for the average investor than using options, which are discussed below. Investors don’t need to set up a margin account since they’re not borrowing money, and the fund manager is doing all the options trading on their behalf. When you think the market is going back up, you can get out of the fund.

Disadvantages: There is some risk that the strategies will not achieve their objective, and in fact, short funds were down this past year, albeit not as far as many of their counterpart long funds.

Tracking error (deviation from index movements) happens because these funds are not perfectly correlated to the index or sector they are following. In a large index like the S&P, there isn’t as much volatility, but the funds that track smaller market sectors such as financials and emerging markets increase volatility in the overall sector because they make up a larger portion of the sector, and the fund itself can suffer from that. Some experts warn against these funds as a means of hedging.

“There should be less volatility in a broad-based index fund,” says White. She recommends that the novice start with passive index inverse funds.

These inverse funds are relatively new, so there is no performance history, and if the fund is actively managed, commissions can be high. If you want low-cost, look for passive inverse funds that track the index. When you sell a fund, you will also realize some short-term gains, which are taxed at ordinary income rates.

Definitions
  • Correlation — a statistical measure of how two securities move in relation to each other.
  • Leverage — Using borrowed funds, or debt, to increase equity returns.
  • Derivatives — financial instruments where the value comes from the underlying asset, which could include stocks, interest rates or currency exchange rates and real estate.
  • Options — A contract that gives a buyer the right, but not the obligation, to buy or sell a particular asset, like a stock.
Options

There are many options strategies for protecting individual stocks. Here is an explanation of two of the more common options: equity collars and protective puts. Both are meant to protect you from a stock dropping below a set point, called the strike price, or exercise price, and are best used for the short term, when you believe the market is volatile or dropping.

If you buy a put and sell a call on a stock you are hedging your bet with a “collar” that won’t allow for much downside or upside variation in the original stock price. So while you limit your risk, you also limit your profit.

Collars are a way to protect against short-term risk, but since they also remove upside potential, you only want to use these for the short term. Since you’re selling the call, you can use the proceeds to offset the price you paid to buy the put, making this a low-cost strategy. Your goal is to protect yourself against temporary volatility, not to realize huge profits.

Puts and married puts: Unlike equity collars, where you limit both risk and profits, here you are buying downside protection, while leaving theoretically unlimited upside potential for the stock.

The difference between puts and married puts is in the time you purchase them. Married puts are bought at the same time as you buy the stock, which gives you immediate protection on the stock. Regular puts can be purchased on a stock at any time.

When you buy puts, you usually buy one contract for every 100 shares of stock that you own. You determine the strike price and the date you want to exercise. A price close to the price of the stock, which is called “At the Money,” gives you the most protection, and is more conservative and expensive because your downside risk is limited. If you want to protect yourself from steep losses, you can purchase a put with a strike price much lower, which is called “Out of the Money.”

Let’s look at an example: If you purchased stock for $100 a share, and a September put for $15, the stock would have to rise to $115 a share by the September exercise date in order for you to break even.

If, on the other hand, the stock drops below $100, you are protected. Remember, the strike price was your “insurance” when you bought the put.

Advantages: If you’re feeling shaky about a stock you own, and it makes up a large part of your portfolio, you can gain some comfort in the insurance.

Disadvantages: Options, including puts and collars, can be fairly complicated, you have to make your own best guess of what the market will do in order to determine the exercise date — never easy in these times. “Options are a fairly sophisticated process for the average investor to figure out,” says Ansari.

“There are so many different elements with selecting the proper date and strike price; it takes time,” White says. She suggests that investors who are new to options start with protective puts, and then move up to collars if they see the need, and are comfortable with the strategy. “With a collar, you need to understand that the stock can be called away — you have to be prepared to lose the stock. That’s not the case with protective puts alone,” she says.

In an equity collar, you lose the unlimited upside of the stock potential, and your profit or loss depends on the strike price. It could be tricky to determine the correct put and call combination that gives you some profit and still protects you against loss.

Puts alone are more expensive to buy than the collar, but with a put, you don’t limit the upside potential of the stock.

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