With the stock market at its second most expensive valuation ever, and under some heavy selling pressure this week, it is a good idea for investors to know how to hedge their portfolios against a correction or a crash.
Step 1: Diversify, Diversify, Diversify
John V. Lintner is a famous economics professor who studied the use of commodities futures to reduce risk in stock and bond portfolios. He was hoping to save investors money over both the long-term and blunt crash scenarios.
He said that the best defense against a stock market downturn is to modify a long-term diversified portfolio of stocks and bonds with non-correlated investments – investments that do not move in lock-step with the overall market.
His study found that this approach would create much less risk at each possible expected return level than a portfolio of stocks and bonds on their own.
Today, just about all categories of stocks and bonds correlate highly to the overall market. Therefore, you first must diversify very broadly as a first step and beyond just the stock market.
That means owning growth and value equities, individual corporate bonds, all size equities including micro-cap, small, large, and medium-capitalization stocks, real estate, REITs, muni bonds, preferred stocks, commodities, managed futures, exchange-traded debt, CEFs, BDC, alternative investments, and options.
Yet even all this won’t be enough because the stock markets have become increasingly correlated with each other, and the Fed cutting rates won't keep equities up for long.
Step 2: Short Major Indices in the Stock Market
One method of hedging your diversified portfolio is to simply short a couple of major indices, such as the S&P 500. That will cover you for the 500 largest U.S. companies.
Another approach would be to short the Russell 2000, which is an index of the smallest 2,000 companies out of the largest 3,000 equities in the stock market.
As many tech stocks, like Netflix, Facebook, and Amazon, account for the largest moves in the market, you could short that sector by shorting the First Trust Dow Jones Internet ETF.
Step 3: Use Covered Call Options
There is a completely different type of stock market hedge you can utilize in the form of covered call options. Covered call options are trades in which you sell the right, but not the obligation, for another party to buy a given stock or ETF from you at a certain strike price on or before a certain expiration date of the contract.
So let's say you own Microsoft and it trades the $135. You could sell a contract two months out for someone to buy Microsoft from you at $135, and they will pay you $2.50 per share for the privilege. You collect that money right now. If you believe Microsoft stock is going to close at or below $135 on that contract expiration date, you will keep the money that you've been paid and the stock.
If Microsoft closes above $135 on the contract expiration date, you'll be forced to sell the Microsoft stock. But that doesn't prevent you from buying it back.
Step 4: Buy Volatility
Finally, you can buy a security that is derived from market volatility. This is an aggressive strategy in which you buy something like the ProShares Ultra VIX Short-Term Futures ETF. When the overall stock market declines, this ETF tends to spike up in price because it is attached to the volatility that goes along with the decline.
The crash IS coming, people. The stock market could have a 50 percent fall coming. Be prepared.
Disclaimer: This article is intended for informational purposes only and should not be taken as investment advice.