With the stock market falling for the next few weeks, or even months, it’s time to rehash how to profit from falling markets one more time. There is nothing worse than closing the barn door after the horses have bolted. No doubt, you will receive a wealth of short selling and hedging ideas from your other research sources and the media at the next market bottom. That is always how it seems to play out. So I am going to get you out ahead of the curve, putting you through a refresher course on how to best trade falling markets now, while stock markets are still only 3% short of an all time high, and unchanged on the year. Market’s could be down 10% by the time this is all over. That is my line in the sand! There is nothing worse than fumbling around in the dark looking for the matches after a storm has knocked the power out. I’m not saying that you should sell short the market right here. But there will come a time when you will need to do so. So here are the best ways to profit from declining stock prices, broken down by security type: Bear ETFs Of course the granddaddy of them all is the ProShares Short S&P 500 Fund (NYSEARCA: SH ), a non-leveraged bear ETF that is supposed to match the fall in the S&P 500 point for point on the downside (see prospectus ). Hence, a 10% decline in the (NYSEARCA: SPY ) is supposed to generate a 10% gain the in the SH. In actual practice, it doesn’t work out like that. The ETF has to pay management operating fees and expenses, which can be substantial. After all, nobody works for free. There is also the “cost of carry,” whereby owners have to pay the price for borrowing and selling short shares. They are also liable for paying the quarterly dividends for the shares they have borrowed, around 2% a year. And then you have to pay the commissions and spread for buying the ETF. Still, individuals can protect themselves from downside exposure in their core portfolios through buying against it. Short-selling is not cheap, but it’s better than watching your gains of the last seven years go up in smoke. Virtually all equity indexes now have bear ETFs. Some of the favorites include the PSQ , a short play on the NASDAQ (see prospectus ), and the DOG , which profits from a plunging Dow average (see prospectus ). My favorite is the RWM , a short play on the Russell 2000, which falls 1.5X faster than the big cap indexes in bear markets (see prospectus ). Leveraged Bear ETFs My favorite is the ProShares Ultra Short S&P 500 (NYSEARCA: SDS ), a 2X leveraged ETF ( prospectus ). A 10% decline in the generates a 20% profit, maybe. Keep in mind that by shorting double the market, you are liable for double the cost of shorting, which can total 5% a year or more. This shows up over time in the tracking error against the underlying index. Therefore, you should date, not marry, this ETF or you might be disappointed. 3X Leveraged Bear ETFs The 3X bear ETFs, like the UltraPro Short S&P 500 (NYSEARCA: SPXU ), are to be avoided like the plague ( prospectus ). First, you have to be pretty good to cover the 8% cost of carry embedded in this fund. They also reset the amount of index they are short at the end of each day, creating an enormous tracking error. Eventually, they all go to zero, and have to be periodically redenominated to keep from doing so. Dealing spreads can be very wide, further added to costs. Yes, I know the charts can be tempting. Leave these for the professional hedge fund intra day traders they are meant for. Buying Put Options For a small amount of capital, you can buy a ton of downside protection. For example, the April $182 puts I bought for $4,872 allowed me to sell short $145,600 worth of large cap stocks at $182 (8 X 100 X $6.09). Go for distant maturities out several months to minimize time decay and damp down daily price volatility. Your market timing better be good with these, because when the market goes against you, put options can go poof, and disappear pretty quickly. That’s why you read this newsletter. Selling Call Options One of the lowest risk ways to coin it in a market heading south is to engage in “buy writes”. This involves selling short call options against stock you already own, but may not want to sell for tax or other reasons. If the market goes sideways, or falls, and the options expire worthless, then the average cost of your shares is effectively lowered. If the shares rise substantially they get called away, but at a higher price, so you make more money. Then you just buy them back on the next dip. It is a win-win-win. I’ll give you a concrete example. Let’s say you own 100 shares of Apple (NASDAQ: AAPL ), which closed on Friday at $95.13, worth $9,513. If you sell short 1 July, 2016 $100 call at $1.30 against them, you take in $130 in premium income ($1.30 X 100 because one call option contract is exercisable into 100 shares). If Apple close2 below $100 on the July 15, 2016 expiration date, the options expire worthless and you keep your stock and the premium. You are then free to repeat the strategy for the following month. If closes anywhere above $100 and your shares get called away, you still make money on the trade. Selling Futures This is what the pros do, as futures contracts trade on countless exchanges around the world for every conceivable stock index or commodity. It is easy to hedge out all of the risk for an entire portfolio of shares by simply selling short futures contracts for a stock index. For example, let’s say you have a portfolio of predominantly large cap stocks worth $100,000. If you sell short 1 June, 2016 contract for the S&P 500 against it, you will eliminate most of the potential losses for your portfolio in a falling market. The margin requirement for one contract is only $5,000. However if you are short the futures and the market rises, then you have a big problem, and the losses can prove ruinous. But most individuals are not set up to trade futures. The educational, financial, and disclosure requirements are beyond mom and pop investing for their retirement fund. Most 401ks and IRAs don’t permit the inclusion of futures contracts. Only 25% of the readers of this letter trade the futures market. Regulators do whatever they can to keep the uninitiated and untrained away from this instrument. That said, get the futures markets right, and it is the quickest way to make a fortune, if your market direction is correct. Buying Volatility Volatility (VIX) is a mathematical construct derived from how much the S&P 500 moves over the next 30 days. You can gain exposure to it through buying the iPath S&P 500 VIX Short Term Futures ETN (NYSEARCA: VXX ), or buying call and put options on the VIX itself. If markets fall, volatility rises, and if markets rise, then volatility falls. You can therefore protect a stock portfolio from losses through buying the VIX. My latest on the VIX is available here . Selling Short IPOs Another way to make money in a down market is to sell short recent initial public offerings. These tend to go down much faster than the main market. That’s because many are held by hot hands, known as “flippers,” and don’t have a broad institutional shareholder base. Many of the recent ones don’t make money and are based on an, as yet, unproven business model. These are the ones that take the biggest hits. Individual IPO stocks can be tough to follow to sell short. But one ETF has done the heavy lifting for you. This is the Renaissance IPO ETF (see prospectus ). Buying Momentum This is another mathematical creation based on the number of rising days over falling days. Rising markets bring increasing momentum, while falling markets produce falling momentum. So selling short momentum produces additional protection during the early stages of a bear market. BlackRock has issued a tailor made ETF to capture just this kind of move through its iShares MSCI Momentum Factor ETF (NYSEARCA: MTUM ) ( prospectus ). Buying Beta Beta, or the magnitude of share price movements, also declines in down markets. So selling short beta provides yet another form of indirect insurance. The PowerShares S&P 500 High Beta Portfolio ETF (NYSEARCA: SPHB ) is another niche product that captures this relationship. The Index is compiled, maintained and calculated by Standard & Poor’s and consists of the 100 stocks from the SPX with the highest sensitivity to market movements, or beta, over the past 12 months. The Fund and the Index are rebalanced and reconstituted quarterly in February, May, August and November. (See prospectus .) Buying Bearish Hedge Funds Another subsector that does well in plunging markets are publicly listed bearish hedge funds. There are a couple of these that are publicly listed and have already started to move. One is the Advisor Shares Active Bear ETF (NYSEARCA: HDGE ) ( prospectus ). Keep in mind that this is an actively managed fund, not an index or mathematical relationship, so the volatility could be large. Oops, Forgot to Hedge Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Summary As the economy is slowing down, it is worth having a look at options to protect your portfolio such as a short ETF. People overestimate their investing skills and therefore are at risk of losing money which can be prevented. ETFs offer the opportunity to investors who simply lack the time or expertise of a certain fund, industry or country but would like to reap the benefits. The water industry has taken a hit the last few weeks, creating numerous buy opportunities. Some people advocate not to invest in ETFs because you diversify too much of your wealth, and as a result, you might diminish your return. Moreover, you pay an additional cost for buying an ETF (the expense ratio). Yet, statistics have always shown that passive traded funds have beaten active funds over an extended period of time . In the same article, it is also shown that a higher expense ratio is often linked to lower performance rates. Furthermore, investors overestimate their ability to predict market events and, therefore, take too much risk in the market. Reasons enough to have a look at what ETFs have to offer. In this article, I will keep it simple and show a wide availability of ETFs which I consider having significant potential for any kind of investor, retiree to value and risk seekers. I always divide a small portion of my portfolio to ETFs to diversify but also to improve my mathematical odds in regards to obtaining better than average returns. The mathematical probability that you pick a winner out of 30 stocks is lower than obtaining a positive return out of an ETF which tracks 30 stocks at once. Furthermore, I sometimes lack the experienced expertise in a specific sector and, therefore, an ETF is a perfect solution to that problem. ETFs for risk-seeking investors As some people are worried about the progress of economies in the world, such as Germany (and as a result slowing down growth and tumbling markets ) I picked a few ETFs which could take advantage of this situation. This is useful for investors who lack knowledge about how to use option strategies or futures to short a market. One can short the American stock market by, for example, buying the ProShares Short QQQ ETF (NYSEARCA: PSQ ) or buying the ProShares Short Dow 30 ETF (NYSEARCA: DOG ). Keep in mind that short ETFs comes at a higher price as their expense ratio is higher than a normal ETF. In Europe, one could use the ProShares UltraShort FTSE Europe ETF (NYSEARCA: EPV ) to short the stock market of England. Plenty of choices and whenever the market tumbles down I would recommend any of these ETFs if you don’t want to be exposed to higher leverage such as with options or futures. As the bull market has been strong the last few years, the short ETFs have been performing dreadfully: While the opposite ETF, the PowerShares QQQ Trust ETF (NASDAQ: QQQ ), has seen outstanding performance over the last 5 years: Just to prove an important point, this is the performance of QQQ in comparison to Ford (NYSE: F ), Boeing (NYSE: BA ), Wal-Mart (NYSE: WMT ) and Exxon Mobil (NYSE: XOM ), 4 large American multinationals: The graph clearly proves the point that holding these 4 large American multinationals would not have outperformed the market over a period of 5 years. This builds a case towards ETF-based investing, especially as the world of academia has shown many times that investors overestimate their ability to predict market events and, therefore, take too much risk on the stock market. One more argument to prove my point is an example of the economy of Brazil. Once a growth economy, now their currency is hitting a shattering low while unemployment is at a 5-year peak. The ProShares UltraShort MSCI Brazil Capped ETF (NYSEARCA: BZQ ) has been through the roof as a result: This was a much easier choice in comparison to cherry picking any of the stocks on the Brazilian market. ETFs to protect against rising interest rates Furthermore, there are products called Exchange Traded Notes, debt instruments which allow the investor to protect themselves against either rising or diminishing interest rates such as these steepeners and flatteners , the iPath U.S. Treasury Steepener ETN (NASDAQ: STPP ) and the iPath U.S. Treasury Flattener ETN (NASDAQ: FLAT ). ETFs for investors seeking value Deep value is hard to find when the stock market is priced at a high P/E. Finding a winner in a bucket of stocks is even more difficult. This is especially the case when it comes to more unknown stocks in sectors which are being ignored by most investors. One of those sectors is the water industry. The water industry comprises of firms that provide drinking water and waste-water services (including sewage water treatment) and irrigation solutions to homes, businesses and manufacturers. The Water Industry (click to enlarge) Source : Water UN The water industry does not receive as much coverage as the solar industry and electric car industry. In my view, this is because the water industry is a bit more boring than the solar and electric car industry. Yet, in my view, it shouldn’t be and there are good reasons for that. Only half a percent of fresh water is being used worldwide while over 1 billion people are still having severe water supply issues: Source : Water UN The water scarcity problem will become much more severe in the coming years: (click to enlarge) Source : Water UN There are 3 water ETFs that play their own individual role in battling the issues of water scarcity. I’ve covered all 3 on Seeking Alpha before: the First Trust ISE Water Index ETF (NYSEARCA: FIW ), the PowerShares Global Water Portfolio ETF (NYSEARCA: PIO ) and the PowerShares Water Resources Portfolio ETF (NYSEARCA: PHO ). Their overall share prices have fallen over the last few months, opening a potential entry point. Conclusion This article is important as it perfectly addresses many of the issues numerous investors currently face – not having the expertise to invest in a sector due to lack of time, wary of investing due to the bull market and the realization that many investors don’t obtain profitable returns overall. Investors tend to overestimate their skills and not every investor is successful. Yet, by following a simple basket of stocks, you enhance your chances of obtaining a positive return while lowering your overall risk. The Brazil ETF clearly indicates that you can also obtain solid above average returns with ETFs. ETFs are an important part of my portfolio due to the above-mentioned reasons. Yet I also hold numerous stocks and financial derivatives in my portfolio (as I work in that specific industry) and consider myself knowledgeable on the industry those firms are active in. When it becomes too specific, I consider ETFs as a good alternative choice. Therefore, I consider the water ETFs as a good value investment for the future. The underlying fundamentals of the water scarcity problems are so underestimated currently in the world that it’s simply a waiting game until investments in these firms will grow significantly. Now is the time to buy these firms. Scarcity of water will spur bright technologists and scientists to invent large scale new technologies in this industry. This will become a very profitable commerce in the future.
Summary As the bull market has continued, so have predictions about its demise. We note the latest one, and the problem presented by such predictions. We discuss ways to limit market risk and describe one method. We show an example of that method using an automated approach. The Latest Bearish Prediction As the current bull market has powered on, there has been no shortage of predictions of its eventual end. The latest such prediction appeared in an article by James Fontanella-Khan and Abash Massoudi in Saturday’s Financial Times (“Value of megadeals this year beats dotcom-boom record to reach $1.2tn”). The authors detailed this year’s record volume of mergers and acquisitions and then warned, But if history is anything to go by, activity might well be at a peak. Data from Dealogic show that sustained deal-making cycles from 1997 to 2000 and from 2005 to 2008 were followed by sharp stock market falls The Problem Presented by Bear Market Predictions The problem presented by bear market predictions such as the one above is what to do with the information, particularly when we’re not given a time frame when we can expect the bear market to begin. If you got out of the market at the first one of these predictions, you would have missed most of the current bull market. On the other hand, if you do nothing to protect yourself, and the prediction comes to pass soon, you may regret your inaction. A solution to this problem is to stay invested, but take steps to limit your market risk. First, we should clarify the difference between market risk and idiosyncratic risk. Market Risk versus Idiosyncratic Risk Idiosyncratic risk , in a portfolio comprised of common stocks, can also be thought of as stock-specific risk: it’s the risk of something bad happening to one of your stocks. The chance that one of the companies you own shares of may become the subject of a criminal probe, as Volkswagen (OTCQX: VLKAY ) recently did , is an example of idiosyncratic risk. Idiosyncratic risk can be limited via diversification. Market risk , or systemic risk, is the risk of a decline in the market as a whole, as happens during crashes and bear markets. Since most stocks decline in those cases, market risk can’t be limited via diversification. In order to limit market risk, you need things in your portfolio that will go up in value when everything else is going down. Ways to Limit Market Risk Adding short positions. If you are short some stocks, most likely those will decline in value during a market decline (ideally, you’d want to be short stocks that will decline even if the market doesn’t decline). Seeking Alpha contributor Chris DeMuth, Jr. offered some specific short ideas in an article earlier this month (“Preparing for a Market Collapse, Part II”). One challenge with this is that you may need to allocate a significant percentage of your portfolio to short positions to significantly limit your market risk. If you allocate half of your portfolio to short positions, for example, by investing exclusively in pairs trades, you can eliminate all market risk, and make your portfolio market neutral. This requires some facility with short selling though. Buying inverse ETFs. These include unleveraged inverse ETFs such as ProShares Short S&P 500 (NYSEARCA: SH ), ProShares Short Russell 2000 (NYSEARCA: RWM ), and ProShares Short Dow 30 (NYSEARCA: DOG ), which seek daily returns equal to -1x the returns of the indexes in their names, and leveraged inverse ETFs, such as ProShares Ultra Short S&P 500 (NYSEARCA: SDS ), and ProShares Ultra Pro Short S&P 500 (NYSEARCA: SPXU ), which seek daily returns equal to -2x and -3x, respectively, the daily returns of their indexes. There are two problems with using inverse ETFs to limit market risk. The first is that, because these ETFs react to their underlying indexes in a linear fashion, as in the case with adding short positions to your portfolio, you would need to allocate a significant percentage of your portfolio to them to significantly limit your market risk. The second problem is that, unlike short positions in individual equities, which can potentially produce positive returns in a bull market, inverse ETFs will produce negative returns. So, they will act as a drag on your performance in up markets. For those two reasons, inverse ETFs are not a good way to limit market risk in a typical portfolio (they can be useful tools for market timers, or for those who wish to bet against a particular country or sector, but neither of those scenarios is the subject of this article). Hedging. An advantage of hedging over the previous two methods of limiting market risk is that, because options react to their underlying securities in a non-linear fashion, a small dollar amount allocated to them can protect a much larger underlying security or portfolio. We showed an example of that, with a particular put option on the S&P 500 ETF (NYSEARCA: SPY ), in an article about the August 24th market meltdown. On that day, SPY dropped 4%, the triple-levered inverse ETF SH rose 13%, and that particular put option on SPY (pictured nearby) was up nearly 80%. Hedging can be used to limit market risk in a diversified portfolio, or to limit both market risk and idiosyncratic risk in a concentrated portfolio. We offered an example of the second kind of hedging in a previous article (“Keeping a small nest egg from cracking”). In this one, we’ll look at hedging market risk in a diversified portfolio. Hedging Market Risk If your portfolio is diversified enough so that your idiosyncratic, or stock-specific risk has been ameliorated, you can hedge market risk by buying optimal put options on ETFs that track a relevant index. Puts (short for put options) are contracts that give you the right to sell a security for a specified price (the strike price) before a specified date (the expiration date). Optimal puts are the ones that will give you the level of protection you are looking for at the lowest cost. Step One: Choose A Proxy Exchange-Traded Fund Although mutual funds and some stocks can’t be hedged directly, you can still hedge a diverse portfolio of mutual funds and non-hedgeable stocks against market risk by buying puts on a suitable exchange-traded fund, or ETF. The first consideration is that the ETF will need to have options traded on it, but most of the most widely-traded ETFs do. The second consideration is that the ETF be invested in same asset class as your portfolio. Let’s assume your portfolio consists of large cap U.S. stocks, or mutual funds that invest in them. An ETF you could use as a proxy would be the SPDR S&P 500 Index , which, as its name suggests, tracks the S&P 500 Index. Step 2: Pick A Number Of Shares In order to hedge an equity portfolio against market risk, you would want to hedge an equivalent dollar amount of your proxy ETF. By dividing the dollar amount of your portfolio by the current share price of your proxy ETF, you can get a number of shares of the ETF that you need to hedge. Bear in mind that options contracts cover round lots of shares (generally, a round lot = 100 shares), so if your number of shares includes an odd lot, you can either hedge the next highest round lot of shares, or slightly over-hedge the next lowest round lot of shares. Step 3: Pick a Threshold Threshold, in this context, means the maximum decline in the value of your position that you are willing to risk. Generally, the larger the decline, the less expensive the hedge, and vice-versa. In some cases, a threshold that’s too small can be so expensive to hedge that the cost of doing so is greater than the loss you are trying to hedge. I sometimes use a 20% decline thresholds when hedging equities, an idea borrowed from a comment by fund manager Dr. John Hussman: An intolerable loss, in my view, is one that requires a heroic recovery simply to break even … 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). Step 4: Find the Optimal Puts Given the time frame over which you are looking to hedge, you’d want to find the put options that would protect you against a greater-than-X% decline (where X is your threshold) at the lowest cost. When doing so, you’d want to keep in mind the cost of the hedge: for example, if you can only tolerate a 20% decline, and there’s a put option with a strike price 20% below the current market price, but it would cost 5% of your portfolio to buy it, then you are actually risking a 25% decline in that case. In most cases, the optimal puts will be out-of-the money, but on occasion they may be in-the-money. An Automated Approach Here we’ll use a hedging app to facilitate finding the optimal puts for an investor with a $787,000 portfolio invested in large cap U.S. stocks, who’s unwilling to risk a decline of more than 20% over the next six months. Steps 1-3: Since our investor is in large cap U.S. stocks, we’ll use SPY as a proxy ETF. So we enter “SPY” in the Ticker Symbol field in the screen capture below. As of Monday’s close, SPY traded at $196.46 per share, so to get our number of shares, we’ll divide 787,000 by 196.46, and enter the result, rounded to the nearest share (“4006”) in the Shares Owned field. In the Threshold field, we enter the largest decline our investor is willing to risk over the next six months, in percentage terms (“20”). Step 4: We tap “Done”, and a few moments later, are presented with the optimal puts: As you can see at the bottom of the screen capture above, the cost of this hedge was $9,960, or 1.27% of our investor’s portfolio value. Note that, to be conservative, the app calculated the cost using the ask price of the puts. In practice, you can often by puts for less (i.e., at some price between the bid and ask), so the actual cost of this hedge would likely have been less. How This Hedge Would Protect Your Portfolio Remember, the reason we picked SPY in this case is because our hypothetical investor’s funds were invested in blue chip US stocks. If those funds drop in value due to a market decline, most likely, the S&P 500 Index will have dropped as well. And if the S&P has dropped, the ETF tracking it, SPY, will have dropped too. If the S&P 500 drops more than 20% — if it drops 20.5%, 30%, 40%, or even more — the put options above will rise in price by at least enough so that the total value of a $787,000 position in SPY + the puts – the initial cost of the puts will have only dropped by 20%, in a worst-case scenario. Hedging A Portfolio Of Stocks And Bonds The example above is simplified in that we’ve assumed our hypothetical investor’s portfolio is entirely invested in equity funds. But what if he had some bonds or bond mutual funds? In that case, we could use a similar process to hedge his portfolio against market risk, except instead of using just one proxy ETF, we’d use one per each asset class. So, for example, if 60% of the investor’s assets were in blue chip US stocks, and 40% in investment grade corporate bonds, we might scan for optimal puts on a number of shares of SPY equal to 60% of the portfolio, and then scan for optimal puts on a number of shares of the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA: LQD ) equal to 40% of the portfolio. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.