Here are three ways you can protect your portfolio from market volatility and a potentially larger move to the downside.

Hedge Your Portfolio

You can liquidate your portfolio and go into cash, but that may cause tax consequences some of you are not prepared to take on yet. If you don’t want to go to cash, you can hedge using inverse ETFs.

An inverse ETF for a specific sector gains in value if the stocks in the ETF decrease in value.  The ETF performance acts inversely to the stocks it holds in the portfolio.

Here’s an example from the Direxion Daily Semiconductor Bear 3X Shares (SOXS) ETF.  This is a triple-leveraged bear ETF, which means it gains/loses 3x the amount of the daily move of the semiconductor industry.  If the semis move down 1% in a day, this ETF will gain 3%.  Likewise, if the semis gain 1% in a day, this ETF will lose 3% in a day.

Now, look at a chart of the semiconductor sector below.  Can you see how the charts sort of mirror one another?  As the semiconductor sector decreases in value (lower chart), the inverse ETF (upper chart increases in value). 

If you’re not experienced with triple leveraged ETFs, I’d start off with a single leveraged bear ETF, but try to find one that is best suited to protect the stocks that you’re trying to protect.  

If you mostly have a blue-chip portfolio, find an inverse ETF that will gain value if blue-chips go down.

Wait, why would I do this?  Don’t I walk away flat in the end?  My stocks go down and the inverse ETF goes up, so doesn’t that mean I’m breaking even?

In this case, hedging is similar to insurance.  I’m not trying to make money from placing a hedge, but I am trying to protect what I already have.  You can also skew your portfolio to be bullish or bearish.  It doesn’t have to be flat.

You can buy and sell inverse ETFs like you would any other stock.  If you think the semis are going down next week, place a hedge, and then take it off a week later if you think the semis are going back up.

Trade Short

For those who have the accounts that allow it, you can sell shares short.  Make sure you fully understand the concept of short selling before you place this type of trade.  Essentially, you profit when the price of the stock goes down.

You know me, I like scans.  I put together a formula looking at the SP500 stocks and their performance over various time frames and devised a worst-performers list.  

These stocks have been absolute stinkers lately and are the latest on my worst-performers scan.  Will they continue to sink?

I don’t know if these will be lower a month from now, but last month I ran the same scan, and selling the five worst would have returned a 9.03% gain in a month.  Not all five were winners, but the bottom five as a portfolio came out ahead.

Buy Top Performing Stocks

Similar to short selling the worst performers, you can also build a portfolio of the best performers.  This current list shows that energy is still the top performer.  These collectively gained over 91%, or 18% average per stock since last month.

While I’ve created a custom scan to help me, you can start by looking at a simple SP500 6-month best performers and worst performers list readily available on several financial websites.  

A portfolio of buying the top five best 6-month performers gained about 11% over this past month.

A portfolio of short-selling the worst five 6-month performers gained 5% over this past month.

Collectively, those 10 stocks returned 16% last month using an equally weighted portfolio.

Do some backtests and see what fits your trading style.

Past performance is not indicative of future results, but I want to give you three ideas of what you can do to hedge against volatility.  

If you have any questions, comments, or anything we can help with, reach us at any time.

Jeff
Guest Writer, Filthy Rich, Dirt Poor
Editor, Wealthy Investor Society