Summary Recent stock market movement has sharpened investor interest in the implications of a significant longer term move on their portfolios. Although a long term downtrend has not been confirmed, plans for hedging the market need to be in place now. Five instruments for hedging a bear market are compared. For almost seven months the S&P500 traded in an amazingly tight range between 2,040 and 2,134 (4.9%). Market watchers are relieved that it has broken out of this range and are alert to the possibility it is the beginning of the next leg up or down. The astute investor will want to prepare for this by having a calmly prepared plan to counteract the S turm und Drang 1 that accompanies such event. Even after the activity of last week the direction of the market is uncertain. In the event the direction will be down, this article reviews some widely available investments that are used to hedge a falling market: -1x inverse index funds -2x inverse index funds -3x inverse index funds Actively managed bear funds Index puts With the possible exception of the -3x funds all investments are assessed in the context of a six month time frame. The objective is to provide portfolio protection in a large market move, not short term speculation. The Question of Timing Determining what constitutes a real change in the market is somewhat of an art, as many investors discovered after oil’s recent false breakout. One indicator used by a number of respected professionals, such as Eric Parnell , is a sustained move below the 200 day moving average. But what constitutes “sustained?” Last October the S&P500 went below its 200 day average for five trading days, which turned out to be a false break. However, times when the 200 day average was broken for more than 10 trading days have been rare. It has occurred only twice in 20 years: March 2001 and June 2008. These signaled a market on the way to the biggest declines in this century. Investors who waited to hedge until the signal was confirmed were still able to benefit from further declines of 37% in 2001 and 49% in 2008. No single indicator is definitive, but the history of the 200 day moving average certainly makes it worth monitoring. The Hedges Bear Index ETFs (-1x): These funds try to obtain results that correspond to the inverse (-1x) of the daily performance of an index. They invest in derivatives and prices move close to the same degree as the underlying index but in the opposite direction. Investors can choose from a variety of broad or narrower indexes, as in these examples: ProShares Short S&P500 (NYSEARCA: SH ) ProShares Short Dow30 (NYSEARCA: DOG ) ProShares Short MSCI EAFE (NYSEARCA: EFZ ) ProShares Short Financials (NYSEARCA: SEF ) Ultrashort Bear Index ETFs (-2x): These funds try to obtain results that correspond to double the inverse (-2x) of the daily performance of an index. There are again many to choose from, such as: ProShares UltraShort S&P500 (NYSEARCA: SDS ) ProShares UltraShort Dow30 (NYSEARCA: DXD ) ProShares UltraShort MSCI Emerging Mkts (NYSEARCA: EEV ) ProShares UltraShort Financials (NYSEARCA: SKF ) 3x Bear ETFs: These funds try to obtain results that correspond to triple the inverse (-3x) of the daily performance of an index. Following the examples above there are: ProShares UltraPro Short S&P500 (NYSEARCA: SPXU ) ProShares UltraPro Short Dow30 (NYSEARCA: SDOW ) ProShares UltraPro Short Financials (NYSEARCA: FINZ ) According to etfdb.com there are 76 bear ETFs available from a variety of companies. There are many indexes to choose from, such as homebuilders (NYSEARCA: HBZ ), banking (NYSEARCA: KRS ), telecom (NYSEARCA: TLL ), China (NYSEARCA: FXP ), and Mexico (NYSEARCA: SMK ). Time has a negative effect on all bear funds because of the nature of their investments and their requirement to rebalance daily (in most cases). This can be severe for the more leveraged funds, as shown by the following chart of SH (-1x), SDS (-2x), and SPXU (-3x) in the flat market from February 10 through August 10. Six month comparison of SH, SDS, SPXU: Because of the time decay and the leverage, most advisors (including Proshares itself), recommend the 2x and 3x funds for short term holdings only. Longer term, if the market direction doesn’t cooperate losses can be large. In the past two rising market years (through 8/19/15) as the S&P500 gained 26% losses for SH, SDS, and SPXU were 26%, 46%, and 62% respectively. However, as short term defensive instruments, these funds are superb. Over the past 5 days, SH, SDS, and SPXU have gained 5.29%, 11.54%, and 16.33% against the S&P500 loss of -5.24%. Five day comparison of SH, SDS, SPXU: Actively managed bear funds: These funds invest in puts and short sales of individual stocks they believe will underperform the rest of the market. The largest is the AdvisorShares Ranger Equity Bear ETF (NYSEARCA: HDGE ). According to its website, the stated objective is ” capital appreciation through short sales of domestically traded equity securities. The Portfolio Manager implements a bottom-up, fundamental, research driven security selection process. In selecting short positions, the Fund seeks to identify securities with low earnings quality or aggressive accounting which may be intended on the part of company management to mask operational deterioration and bolster the reported earnings per share over a short time period. In addition, the Portfolio Manager seeks to identify earnings driven events that may act as a catalyst to the price decline of a security, such as downwards earnings revisions or reduced forward guidance .” HDGE has been in business since 2011 — a difficult period for bears. In the flat six month market up to August 19 it had a decent performance of +1.84% vs. -1.54% for the S&P500. In the last 5 days it is up +4.88% vs. -5.24% for the S&P500. Overall it has performed close to a rate of 1x the inverse of the broader market. S&P500 Put Options: The topic of options is so vast that the discussion in a short article like this must be very limited. We will focus on purchasing six month at-the-money S&P500 put options as a hedge against the decline of the broader index represented by the SPDR S&P 500 ETF (NYSEARCA: SPY ). The great advantage of options is that they allow the buyer to control a large number of shares for a small investment. Using the six month at-the-money 198 put as an example, the cost as of August 23 is 11.91. Options are sold in lots of 100. For $1191 the buyer controls $19800 of SPY, equivalent to16x leverage. The tradeoff for this is that options expire after a fixed period and the price includes a time premium. To book a gain on this option SPY has to decline in an amount greater than the time premium, which is 6% (11.91/198). In six months, SPY will have to be close to 186 (198-11.91) just to break even as the time premium disappears. Excluding the brief drop last October, the last time SPY was at this level was April 2014. Large drops in the index before expiration will result in big gains. On Friday, August 21 alone, the six month at-the-money 204 option rose 2.18, or 19%. Comparison and Recommendations The chart below summarizes the performance of the instruments discussed in the flat market of year-to-date ending August 19 and the sharp move of August 20-21. The SPY put YTD loss is based on a six month put expiring at the money. Investment objective YTD to 8/19 8/20-8/21 SPY ATM put S&P500 6 mo. put -100.0% 32.8% est. HDGE active managed bear -3.5% 4.6% SH 1x short index bear -3.6% 4.9% SDS 2x short index bear -7.1% 10.1% SPXU 3x short index bear -11.6% 15.0% S&P500 reference 1.0% -5.20% To have true portfolio protection a significant portion of a portfolio must be covered. The unleveraged short ETFs discussed here only protect an amount equal to what’s invested. So, for example, putting $10,000 in HDGE or SH protects $10,000 of a portfolio. If one’s portfolio is much larger, say $100,000, $10,000 in hedges leaves 90% unprotected. SPY puts are more complex. The buyer can control a large number of shares, but they expire at a specific date and part of the cost may be a time premium. As the chart shows, they can provide big short term gains; over the longer term they are designed to move in an inverse one to one ratio with the underlying S&P500 minus the time decay. The 2x and 3x leveraged instruments are an efficient way to insure a significant amount of the portfolio without a time premium or expiration. 50% of a $100,000 portfolio can be fully hedged (insured) by $25,000 of -2x SDS and only $16,666 of -3x SPXU. Based on the above chart, in a flat market similar to the past eight months this insurance with SDS would cost you $1,775(-7.1% of $25,000). The same insurance with SPXU would cost $2,900 (-11.6% of $25,000). This insurance cost would quickly be covered by a 3.8% decline in the S&P500 (-3.8% x -2x SDS = +7.6%; -3.8% x -3x SPXU = +11.4%) Any discussion of leveraged inverse funds such as SDS and SPXU (as well as their bull counterparts SSO and UPRO) must acknowledge their significant risk. Market moves in the wrong direction are very damaging, and they will lose value in a flat market or in times of high volatility. In the recent six month flat market SDS lost 8% and SPXU lost 13%. On the other hand, after the recent market drop both SDS and SPXU are up 3% year to date. Readers can get a better understanding of the risks by studying how these funds performed under various market conditions in the past. The best hedge for a down market depends on each individual’s risk tolerance and time horizon. However, an important consideration is having enough of the portfolio protected. The unleveraged hedges discussed here (actively managed bear funds and 1x inverse index funds) require a large dollar for dollar investment for protection. If an investor can accept the risk, leveraged 2x inverse index fund and 3x inverse fund can insure more of a portfolio for less money. Index put options are another low cost choice with their own unique characteristics. 1 Sturm und Drang: “… literally “Storm and Drive”, “Storm and Urge”, though conventionally translated as “Storm and Stress”) is a proto-Romantic movement in German literature and music taking place from the late 1760s to the early 1780s, in which individual subjectivity and, in particular, extremes of emotion were given free expression …” — Wikipedia. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SDS over 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.