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.