Reassessing Portfolio Allocations, Risk Profile: 5 Strategies for Volatile Markets

by: Dhinesh Ganapathiappan

In light of the markets' wild ride recently, here are some strategies to help protect your investments. The S&P downgrade of the United States credit rating to AA+, high unemployment, and low economic growth underscore the structural problems facing the US economy. Investors that witnessed the 2000 and 2008 crashes may be tempted to pull out completely, but re-assessing your portfolio allocations and risk profile may be a better idea by using bonds, gold, and options.

1) Buy High Quality Bonds

Bonds have performed well during the market rally and even the recent downturn. Treasuries have risen as investors flee risky assets and see few areas to deploy excess capital. Low yields and the credit downgrade make government debt unattractive relative to corporate, municipal, and international bonds, though.

Large US corporations that are flush with cash make great borrowers. The iShares iBoxx Investment Grade Corp Bond ETF (NYSEARCA:LQD) is a good diversified option with a 4.5% yield from high quality names like AT&T (NYSE:T). In the current environment, these bonds are preferred to non-investment grade junk bonds like SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK). The speculative borrowers in the junk bond space have recently enjoyed historically low yields and taken full advantage by locking in large borrowings at low yields. The spread on owning a riskier junk bond versus an investment grade bond has been historically low, which leaves JNK vulnerable to a pullback as investors reassess and require higher yields.

In the muni space, bonds have mimicked Treasuries in price action during the market downturn, however they offer more attractive net yields after exemptions from federal and state taxes are factored in. A comprehensive list of muni ETFs can be found here.

Internationally, apart from hotspots like parts of Europe, government bonds offer attractive yields and risk profiles. Even in the emerging markets, there is a high degree of certainty that debts will be paid and growth continues. Some top picks in the universe include SPDR DB Intl Govt Infl-Protected Bond (NYSEARCA:WIP), PowerShares Emerging Mkts Sovereign Debt (NYSEARCA:PCY), and SPDR Barclays Capital Intl Corp Bond (NYSEARCA:IBND). A comprehensive list of international bond ETFs can be found here.

2) Buy Gold

In an uncertain world fueled by debt, gold is the ultimate safe haven and hard asset. Gold has been a steady performer over the decade and still has upside potential from seemingly lofty levels. Gold is up over five-fold from 2000 levels and has never had a down year since 2001. It has a tendency to become an over-crowded trade but the current run does not seem to reflect that euphoria yet. Institutional and retail investor demand is propelling it higher, and central banks are also adding gold to diversify paper holdings. In an economic contraction, silver becomes less desired to gold since it primarily has industrial uses, so don't expect a run in silver or other metals. SPDR Gold Shares (NYSEARCA:GLD) is the preferred way to invest in bullion. For a leveraged position, use PowerShares DB Gold Double Long ETN (NYSEARCA:DGP).

3) Substitute Deep in-the-Money Calls for Stock Positions

This strategy will define the maximum loss you can take on a position, and by using options that are well in the money, minimize cost. For example, if you are holding a position of US Steel Corp (NYSE:X) at $33 a share, you can purchase $20 January 2012 call for about $14. This limits your maximum loss on the stock to $14 per share, or 42%. You will still participate to the upside as you would with owning shares of stock, and the premium is only about 3%. This premium will decay slowly so if you decide to sell in the future, you likely will not lose the entire 3%. Additionally, if the stock does decline to the strike price before expiration, you will still be able to close for a residual premium that you would not have if you just owned the stock. Paying 2-5% for protecting from massive losses is a small price to pay.

4) Get Put Protection

The alternative to buying deep-in-the-money calls is to purchase protective puts for your positions. The end result is similar, but owning the call is generally simpler to trade and keep track of. If the sell-off continues and you want to bargain-hunt, either of these derivative strategies are good for defining risk and the maximum loss you may take, without limiting upside.

5) Option Spreads

With heightened volatility and option premiums rising with the VIX, one way to get exposure while defining and minimizing risk is with option spreads. More details on the strategy can be found online, but it is especially useful to speculate further out-of-the-money with little cash outlay. Payoffs of 4:1 can be had this way.

If you are uncertain of where the market will be in the future and don't want to attempt to predict the direction, you can use the short iron condor option strategy, which is essentially a combination of a bullish call spread and bearish put spread. As long as the underlying asset moves far enough by expiration to reach or exceed your outer call or put, it will be profitable. These spreads can give exposure to profits with limited capital risk.

Disclosure: I am long GLD.