How to Leverage Returns in Case of a Correction

by: ChartProphet

The S&P 500 recently hit the 100 percent return mark since its 2009 lows. A 100 percent move is not only tremendously impressive, but also highly psychological, in that investors are aware of the market's huge gains over the past two years, and are likely to take some of their gains off the table and wait for new opportunities to add to their positions or enter again. Add to that the facts that such a huge run-up is almost unheard of in the past 100 years; that unemployment is still plaguing our economy; that surging commodity prices may begin to affect company earnings and future profits; that emerging markets are lagging behind the U.S. market; and that the Middle East turmoil may have a lot more consequences than we allow ourselves to believe, and it looks like we are almost certainly due for a correction.

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It seems as if the market has "melted up'"even though many investors have been anticipating a correction. The market has continued to run up, offering almost no opportunities for investors to buy stock without chasing. And consumer confidence recently hit a high that has not been seen in three years.

With consumers, investors, and almost everyone I read about or speak to believing in this rally and the recovery, I am left almost alone wondering if this is the exact time to not only exercise caution, but to actually start betting on a correction. It's been less than six months since the market was teetering on the edge of a "double-dip" recession, but if you take a look around, there are almost no remnants of the extreme pessimism that took hold of investors' minds only this past summer.

I understand that the economy has improved, but after such a huge run and almost complete recovery of consumer and investor confidence (along with the largely ignored problems on the horizon), I think it's time to start gearing our portfolios for a correction.

Times like these reward those who take the time to protect their portfolios through hedging, pair trading, or options strategies. We therefore have compiled a list of stocks, ETFs, options, and strategies that will at least offer you protection in case of a market pullback. If you think the chances of a correction are relatively high (which we do), you may even want to take on bigger positions in these trades -- though please keep in mind that these are highly leveraged strategies that may multiply your gains or losses by as much as three or more times the actual market move. Please maintain some caution.

Your choices right now:

  1. Keep your investments, but risk big losses if the market pulls back.
  2. Sell your investments now and wait for a pullback to get in again, but risk missing out if the market continues to run up.
  3. Keep your investments, but protect yourself from losses by hedging through options or pairing them by shorting stocks and ETFs you think will underperform.
  4. Sell your investments now and place some bets on a market correction.

If you think the market will pull back here, we recommend choices 2, 3, or 4. In order of risk (from low to high): 2, 3, 1, 4. We think that placing some small bets on a market correction could turn out to be very profitable, and at least keep your portfolio protected for the next few months. And since picking individual stocks to short is both risky and difficult, our list of strategies involves broad themes and sectors that could pay off in a market correction -- regardless of how individual names perform.

Moreover, rather than placing bets that correspond to the underlying stocks, sectors, or themes in a 1:1 ratio, we think a good bet (though riskier) for a market correction is one that is leveraged at a 2:1 or 3:1 ratio. In other words, many of our strategies allow you to place a smaller bet, but allow yourself a two-fold or three-fold return off the market's move.

Here are our favorite ways to leverage gains in a correction:

Short Emerging Markets. With extreme investor interest in the "emerging markets" theme over the past few years, we think placing some bets against this hot trade could pay off. China, India, Brazil, and others have attracted investments in huge numbers as investors have looked for growing markets with promising futures. But with emerging market sentiment at extreme highs, and much of the future growth already factored into the price (in our opinion), a considerable correction may be forthcoming. And with China and others fighting rapid inflation by raising interest rates in order to slow down the nearly uncontrollable growth, a shock to the markets is not unlikely.

Our favorite play to take advantage of an emerging market pullback is the Emerging Markets Bear 3x ETF (NYSEARCA:EDZ). This ETF is a triple-leveraged trade against emerging markets. If emerging markets continue to struggle, EDZ will provide you with three times the return. Keep in mind EDZ is already a short ETF, so you would be going long on this trade to short emerging markets. But since buying the ETF outright could pose high risk, we recommend buying April or July call options, which will allow you to limit your risk and leverage your potential gains.

If you think individual countries will suffer, you can short those as well. The country with some of the most positive sentiment, and probably the one with the most potential of a pullback (in our opinion), is China. To short China, we recommend going long the Ultrashort China (NYSEARCA:FXP), the leveraged inverse trade to FXI. Again, we recommend doing so through call options, in order to limit your risk.

Other countries you may want to short individually are Brazil (NYSEARCA:EWZ) and India (NYSEARCA:EPI). We think buying EDZ calls will provide you with the best returns or protection, though.

Short Small Cap Stocks. In a market correction, small companies generally suffer the most as investors flee to the more stable, well-known names. Companies in the Russell 2000, an index of small-cap stocks, would therefore be at risk of larger pullbacks than the larger-cap stocks in the S&P 500 or Dow Jones Industrials.
Rather than picking individual stocks to short, which could result in large losses if you happen to choose the wrong stock, we think it's much easier and less risky to short the Russell 2000 index -- which would very likely see a drop if the overall market corrects -- as a whole.

Your two choices to short the Russell 2000 are either through the IWM, which tracks the Russell 2000 at approximately a 1:1 ratio, or through the Small Cap Bear 3x (NYSEARCA:TZA), which we recommend as the better choice. The triple-leveraged TZA offers much higher returns and a much better way to protect your portfolio in case of a pullback. Again, we recommend doing so through call options. With the leveraged TZA, however, you can bet one-third of the amount that you normally would and still allow yourself to get the full reward of the IWM.

Short Financials. Largely what got us into this past financial mess and recession we supposedly recovered from, the financial sector is still at high risk of further write-downs, increased regulation, and potential upheavals. And with fairly strong overhead resistance at $17 in the Financial ETF (NYSEARCA:XLF), which tracks the broader financial sector, shorting the financials could prove to be one of the better trades in a correction.

In order to leverage the financial short, we recommend the Financial Bear 3x ETF (NYSEARCA:FAZ) or the Ultrashort Financials ETF (NYSEARCA:SKF). Rather than having to choose between individual financial names, the broad financial short could help protect your portfolio or take advantage of overall weakness in the sector. Call options recommended once again.

Short Agriculture. One of the top themes of the past year has been the agriculture play. As worldwide demand grows and prices continue to soar, agriculture stocks and ETFs are expected to benefit tremendously. In our opinion, however, the agriculture and commodity theme is highly saturated already, and depends on continued high global demand and growth. If demand or growth don't continue as predicted, these stocks could suffer greatly. Stocks like Potash (NYSE:POT), Mosaic (NYSE:MOS), Monsanto (NYSE:MON), Caterpillar (NYSE:CAT), and Deere (NYSE:DE) have already seen massive runs. We think there is a lot of risk in this theme.

To protect yourself, then, we recommend shorting the agriculture play by shorting the Agribusiness ETF (NYSEARCA:MOO) or Agriculture ETF (NYSEARCA:DBA), or leveraging it by shorting the Double Long Agriculture ETF (NYSEARCA:DAG).

Short Gold or Silver. Though gold and silver are expected to gain if the market drops, as investors flee to safety, we're not so sure if these precious metals are truly as "safe" as many believe them to be. If gold and silver have become speculative trades, as we think they have, they may drop together with the rest of the market. Either way, however, maintaining some gold and silver shorts through options or small ETF positions could provide you with some protection as well.

The most basic ways to play gold and silver is through their ETFs: GLD and SLV, respectively. A more leveraged way to play these is by shorting the gold miners (NYSEARCA:GDX), junior gold miners (NYSEARCA:GDXJ), or the Ultra Silver ETF (NYSEARCA:AGQ), or by going long the Gold Double Short ETF (NYSEARCA:DZZ).

As always, maintain caution and limit your risk. Know your entry and exit points, and make sure to hedge your positions. The trades we have discussed are fairly risky ways to gear up for a market correction, as they are leveraged plays on very popular momentum themes of the past two years. Following these strategies through options will allow you to limit your risk and protect your portfolio, and could even make you some nice gains if the market does in fact pull back. You have many choices though; you could protect your current long positions, initiate bets on a market pullback, and even leverage potential gains while limiting your risk.

Disclosure: I am long EDZ, FXP.

Additional disclosure: I am also short DBA (through ETFs) and GDX, SLV, and MOO (through options)