3 Ways to Profit from a Market Drop

Includes: QID, SDS, SKF, VXX
by: Aaron Katsman

With the stock market up by more than 60% in a short amount of time, many investors are getting skittish about near-term market prospects. The global economic picture is cloudy at best, corporate earnings have been so-so, and investors fear that China is going to try and rein in bank lending in order to cool off surging inflation and avoid a real estate bubble. These fears have already led to a limited short-term market drop. Adding insult to injury, U.S. President Barack Obama is poised to impose harsh regulations on US banks by limiting their size, profitability, and the sectors that they can conduct business in. By kowtowing to a populist movement that wants to stick it to the banking industry for ‘making too much money’ and ‘paying out large bonuses’, the President risks further dampening investor optimism, bringing about a short-term decline.

For investors worried about a serious market correction, the obvious question is how to protect an investment portfolio from taking a big hit? Is there even a way to profit from a market drop?

While there are many different solutions to this question, I would like to focus on 3 approaches to both hedge and profit from a stock market drop.

Inverse ETFs
As I wrote in this column previously, Exchange Traded Funds (ETFs) are defined as “securities that track an index, a commodity or a basket of assets like an index fund, but trade like a stock on an exchange.” For example, if an investor wants exposure to the S&P 500 stock index, he can either buy all 500 stocks, which would be very costly and time consuming, or he can purchase an ETF. Most investors use ETFs because they want a low cost, non-managed way to capitalize on a stock market rally.

Recently, however, new ‘inverse’ ETFs allow investors to profit from a market decline. If the market goes down, they should go up and vice versa. Inverse ETFs are now available for most major market indices and sectors. For example, if an investor thinks that Obama’s proposed regulation will in fact drive down shares of banks, he could choose to profit from the decline by purchasing an inverse ETF linked to the banking index.

Many professional investors like to look at market volatility as an indicator of future stock market performance. The VIX Chicago Board Options Exchange (CBOE) Volatility Index, shows the market’s expectation of 30-day volatility. The VIX is a widely used measure of market risk and is often referred to as the “investor fear gauge”.

Edward Szado, a research analyst for the Center for International Securities and Derivatives Markets, University of Massachusetts, said in Marketwatch.com, “Investable VIX products could have been used to provide some much-needed diversification during the crisis of 2008.” He continued, “The performance of markets in recent years suggests that VIX may spike upwards as the S&P 500 experiences large drops, leading one to believe that a long VIX position could provide significant diversification benefits to an equity portfolio.”
There are a few new products structured to capitalize on movements in the VIX. Keep in mind that investing in volatility is very new for most investors and comes with risks. Investors need to take the time to understand how these products work.

The classic way to cushion your portfolio against a market drop is by buying ‘insurance’. Buying put options as an insurance policy on your portfolio is like having homeowners insurance to protect your house against a fire. A ‘put’ is an option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. A ‘put’ option is basically a bet that the market will drop. If it does, the investor makes money. If wrong, the initial investment in the put is lost.
While these methods may be an effective way to profit from market decline, they can be quite complicated to implement. Speak with your financial advisor to see if these approaches fit your risk profile and whether they have a place in your portfolio.

Author's Disclosure: none