With the major U.S. indices struggling to find solid footing for a continued rally, there’s a lot of concern we may be entering a bear market.
The problem with a bear market or a recession is that there’s no real way to tell you’re in one until it’s already too late. Sure, there are technical signals to look out for. There are historical patterns that can help predict them. But really, when you get right down to it, you’re not going to know until you’re already there.
I know that’s a scary fact to digest. But there’s a silver lining. And that’s your ability to build a portfolio to provide both profits in good times and protection in times of turmoil...
Lessons from the Pros
Well, everything I said was true. But that doesn’t mean we can’t learn something from those hedge funds. And it doesn’t mean they’re doing everything wrong, either.
You see, the word “hedge” in hedge fund refers to the practice of hedging investments against losses. I’m sure you’ve heard someone say something about hedging bets in passing. Well, that’s exactly what they’re talking about.
You use part of your portfolio to bet against your own trades. That way, no matter which direction the market moves, you’re covered. If your positions go up, the profits from your long investments grow. If the market drops, your short positions become profitable. Either way, you’ve reduced some of the risk from a market crash.
But there are a ton of different ways you can do this. And depending on where you think the market is heading in the short term, there are a ton of options as to how much you use to hedge.Get Shorty
The easiest way to bet against the market is to go short. That’s when you literally borrow shares of a stock, fund, or other investment vehicle and sell them to someone else.
Your goal when you go short is to borrow and sell the shares at a high price and then buy the shares back on the market at a lower price to “pay back” your loan.
If you’re successful in your strategy, you can turn a tidy profit as a market, industry, or company drops in value.
It’s easy. It’s not complicated. And it can be both super profitable and provide an excellent cushion for your portfolio when markets go south.
But there’s a downside to shorting. And it’s a massive downside. You see, the thing is when you short a stock, you can make up to 100% profit when you close your position. Say you borrowed the shares at $50 and were able to close the position after a bankruptcy at no cost — you’ve made a 100% return.
But say those shares rally after you borrow them for $50. Now you’ve got to cover your short position at a price of $150 a share. You’ve just lost 200%.
And that’s the thing with shorts. Your profits are limited, but your losses are limitless. If a short goes the wrong way, you can find yourself bankrupt.
That’s why I personally prefer some of the other methods of betting against the market and hedging my portfolio...
My preferred methods for hedging are a lot less risky when it comes to downside. All I can lose is 100% of my investment. I don’t want to, but I’m OK if it happens. I haven’t lost any more than I had. I can still recover from that loss. A 25,000% loss can end you, though.
Put in a Call
Options — calls and puts — are just contracts that give you the right to buy or sell a security at an agreed-upon price.
If you buy the contracts, you have the right to buy or sell the underlying assets. If you sell the contracts, you’ve got the obligation to buy or sell those assets.
And when you think a market or company is about to hit the skids, they’re a cheap and effective way to make a bet against a security.
You can either sell calls or buy puts. Either way, you’re making a bet that the stock or fund is going down. If you sell the calls, you’re hoping prices of the stock fall below your strike price — the pre-negotiated price you’ll sell shares for.
If the price falls far enough below the strike, there’s no reason for the call option to get exercised, and you keep all the money you got paid when you sold it.
If you don’t want to wait for the call to expire, you can buy it back at its new, lower price and take your profit to go.
With puts, it’s very similar, but since they give the owner the right to sell a stock at a certain price, you’d be looking to buy them if you think the market’s going down.
Once you’ve bought the puts, you now have the right to sell shares of the underlying asset at the pre-negotiated strike price. If shares are selling cheaper than that on the market, you still get to collect your payment. Or, again, if you don’t want to deal with the shares and don’t want to wait for the option to expire, once share prices go up, you can sell your put contracts at an elevated price.
Now, options move quickly. And you can bank a pretty serious loss in just a few days, sometimes even hours. But they’re a cheap, easy, and effective way to hedge your portfolio against market corrections. And they’re a heck of a lot less risky than short trades.Go Fund Yourself
Finally, there are exchange-traded funds (ETFs) that let you take a short position without all the risk of limitless losses. They’re called inverse ETFs. And they’re another solid option for hedging against stock market downturns.
Basically, you get to buy shares of a basket of short positions. You get the potential upside of the shorts going wild during a market collapse. But you don’t have to take on the risk of infinite losses.
Since you’re buying shares in the fund, you can only lose what you invest. Nobody ever wants to think about losing an entire investment. But I can’t impress enough how much easier it is to come back from a 100% loss than it is to come back from a 1,000%, 10,000%, or even 100,000% loss.
There are tons of options for finding inverse ETFs, too. You can pick an index like the S&P 500 and buy a fund that seeks to perform the exact opposite of the index.
You can bet against a particular industry or sector with inverse oil ETFs or inverse financial ETFs.
You can even bet against currencies and commodities with these tricky little investments.
Your main concern with the funds is going to be their fee structure. How much do you have to pay for the privilege of owning them? If you’re paying too much, you’re eroding your hedge and reducing your safety factor.
You also want to look at trading volume. That’s going to let you know how liquid the fund is. Are you going to be able to sell your way out easily? Or is it going to take a couple days for a buyer to come around?
You want funds with low fees and high volume/shares outstanding. That way you’re not paying out all your profits to own the fund, and when you’re ready to sell, you can be sure there’s a buyer.
Get Buy with a Little Help from Your Friends
I tried to make hedging strategies as simple as possible today. But I understand there’s a lot of hesitation when it comes to using them. It’s human nature to see the bright side of things. It’s our nature to bet on positive outcomes. It’s really tough to break through that and make a bet against something.
And even when we do, it’s tough to handle the fact that we’re sacrificing some profits now for protection in the future.
But with the proper strategy, some patience, and a steel stomach, a properly hedged portfolio will give you both peace of mind during bear markets and impressive gains during the rallies.
And that’s why my partner at The Wealth Advisory, Briton Ryle, and I are putting together a report and presentation for you, our valued Wealth Daily nation, that will detail exactly what you need to do to prepare and protect yourself against a crash and how to react once it happens.
You’ll get advice on hedging your bets to avoid the coming sell-off. And you’ll learn how to maximize your gains as the market turns back up and starts to run again.
We’re still finalizing everything. But as soon as it’s ready, we’ll debut our research and recommendations here. That way you’ll be the absolute first to be able to take advantage of the information.
Don’t worry, we’ll have it out in time for you to get ready. And as soon as we’ve got it out, you’ll be the first to know.
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