How You Can Protect Your Stock Market Gains

| October 19, 2011

The markets have been on fire over the last couple of weeks. Since the route ended last month, the Dow and S&P 500 have climbed over 9%. And the NASDAQ is up a massive 11%!

But despite the market’s strong performance, it may not yet be out of the woods. If the EU fails to get the sovereign debt crisis under control, we could easily see stocks tank yet again.

So how can you protect your portfolio’s value?

The answer’s simple… just hedge it!

Now, I’m not talking about investing in hedge funds or short selling stocks. There’s a much easier way… And I’m going to tell you all about it in a minute. But first let me explain what I mean by “hedge”.

The dictionary defines hedge as follows… “To protect oneself financially: to minimize the risk of a bet.” Unfortunately, this basic definition leaves a lot unsaid. There’s a whole lot more detail involved in a financial hedge.

First off, there are a number of ways you can hedge your portfolio. For example, you could sell all of your holdings outright. You can’t lose money if you’re not invested… but you won’t make any either.

Or you can use sell stops on your positions. These are handy to get you out of a stock when the bottom is falling out. But they only help cut your losses. They don’t give you the ability to make a profit.

And what if you don’t want to sell position? Maybe you don’t want to create a taxable event. Or may you just really like the company.

The point is sometimes an investor is just looking to protect his portfolio from losing value. The question is, how do you do it?

That’s where a hedge comes in…

When you hedge, you leave your positions in place. Instead of selling, you create a new position that can profit if the market goes against your existing investments. In other words, if one of your stocks goes down in value (or even your whole portfolio)… your hedge position should increase in value to offset or eliminate the losses.

Let’s take a look at a specific hedging strategy to show you what I mean.

One of my favorite ways to hedge is with currencies. Here’s why…

Many currencies trade in a pretty strong relationship with the stock markets. Some currencies trade higher along with stocks while others trade lower. I’m focused on using the US Dollar, which mostly trades in the opposite direction of the major stock indexes.

If you hold stocks, ETFs, mutual funds, etc… you’re always looking for the market to move higher. But if you feel the market has run out of steam, you can simply put on a hedge.

Here’s a basic example of using a currency ETF as a hedge…

Now before we get to the actual numbers, one of the first things to consider is how much of a hedge do you want to put on. To figure that out, you’ll need to know how much of your position or portfolio you want to protect.

While there are many strategies pros use when hedging, let’s use the simplest one. We’re going to hedge our position 100%, or put on a full hedge.

Now if we think the market will head lower, we want to buy something that will move higher. This is the key… your hedge needs to move in the opposite direction of the investments you’re trying to protect.

If your hedge has no relationship to the investment you are protecting, then it’s really not a true hedge.

So back to our example…

We’re concerned the stock market is about to move lower. So we buy the good ol’ US Dollar. Remember, if stocks head south, the Dollar should rise in value.

The ETF for the US Dollar is the PowerShares DB US Dollar Index Bullish Fund (UUP). Take a look at the chart below to see how strong the relationship is between the S&P 500 and the US Dollar. For our example, I’m using the September selloff timeframe.

UUP vs. SPY Chart

As you can see, the S&P 500 lost 6.77% in late September. However, at the same time, the Dollar gained 5.97%. Clearly, the greenback has a strong inverse correlation with stocks.

So here’s how you could have used the US Dollar as a hedge…

Let’s say you own $10,000 of SPY, the S&P 500 Index ETF. And on August 30th, you decided you wanted to hedge your SPY position. To put on a full hedge, you would buy $10,000 worth of UUP, the US Dollar ETF. Now your position is fully hedged.

When the markets fell 6.7%, your SPY position would have lost $670 in value. But since you fully hedged the position, the numbers look much better. In fact, UUP going up by 5.97%, you’d have made $597 in UUP.

Bottom line…

Your hedge would have reduced your SPY loss from $697 to just $73!

Now here’s how you make the hedge really work for you.

Once you feel the markets are turning, you can take your hedge off by selling UUP for a profit… and, of course you’d keep any gains made on SPY! So in our example, you never sold your original investment, but you offset your short-term loss in value with gains from your hedge position.

Now, this was a very simplified example of how a hedge works. More specifically, it was an example of how to hedge a stock market index using a currency ETF.

In a future article, I’ll get into how we can use other hedging strategies to protect your portfolio. For now, know that UUP often makes a great hedge for the S&P 500 index, and the stocks included in it.

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Category: Stocks

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