As the self-feeding fear machine runs rampant, where can investors turn for protection? I think there are still a few good plays out there but you will need to exercise a lot of caution and understand that these are some of the most risky times to play the markets.
Gold: I still see a significant upside for the price of gold. I estimate that we may see gold as high as $2,500 within the next three to six months. Fear drives investors to the seeming safe-haven of gold, and few other alternatives exist. Small leveraged bets on the price of gold could be prudent, such as options on futures and options on gold-based ETFs such as the SPDR Gold Shares (GLD) or buying into leveraged gold ETFs such as FactorShares 2x Gold Bull/S&P500 Bear (FSG), ProShares Ultra Gold (UGL), and Deutsche Bank AG DB Gold Double (DGP). Just be cautious of the downside risk once gold goes parabolic.
Shorting the Market: Some people use market timing strategies to switch between going long and short in the market. The all-short mentality can be tough. For most investors, it may be prudent to use shorting tactics as a hedge against a long position. When the market softens and is heading down, consider allocating a certain percentage of your funds into leveraged short ETFs. A few are the Direxion Daily Financial Bear 3x (FAZ), Large Cap Bear 3x (BGZ), ProShares UltraShort Technology (REW), or the Rydex Inverse 2x S&P 500 (RSW). If you are particularly bearish on a certain sector, you can specialize with an ETF or simply short an entire index with our without leverage.
VIX: The volatility index is another vehicle that many use as a hedge. I must admit this is not my favorite way to protect, but it does have its place. As the market drops, volatility rises. I think that a small position in the VIX is suitable when the VIX is low, but I'm cautious when the VIX is extended. If the VIX soared up to 90, how much more of an upside could you expect? Because the VIX is based on relative volatility measures, you could watch your stocks drop over time without making a net profit in the VIX. This form of hedging is good for one day shock drops or for short periods of time when the VIX is relatively low, but I am a bit leery of using the VIX once a bad market is in full force. Still, it is a hedge worthy of consideration. You can look at the iPath S&P 500 VIX Short-Term Futures (VXX) or an even wilder swing using the leveraged VIX with VelocityShares Daily 2x (TVIX).
Selling Put Options: Another excellent way to protect yourself against a down market is to use cash-secured Put options. One tactic is to sell Put options as long as you have enough cash on hand to buy the shares if prices fall that far.
For instance, you like the stock Priceline (PCLN) but are afraid to invest during the market correction. The current price is $462.40. You'd be happy to buy at $400 after the mayhem. Instead of waiting, hoping, and losing out, sell Put options that expire in January 2012 with a $400 strike price. If prices are $400 or below in January, you will need to purchase shares. The premium you collect for this contract is $27.30 per share. Your break-even point is if shares fall to $372.70, which represents you purchasing shares at $400 and subtracting your options premiums. Thus, prices can fall over 19% in five months and you still break even. If prices are at or above $400 per share, you earn 7.3% in five months based on your risk capital ($400 - $27.30), and averaged over one year this works out to 17.6% profit. This can create a net profit income source in corrections, bull markets, and a powerful hedge in major crashes. This tactic works well when options premiums are higher due to rocketing implied volatilities such as we are having now.
Purchasing Put Options: This is a simple method of buying insurance on shares you already own. As your share prices drop, your options will increase in value due to higher implied volatilities and increasing intrinsic values. I prefer selling cash-secured Puts as opposed to buying Puts as this form of insurance can be expensive during market corrections or crashes (due to high implied volatilities), and it does little for you when markets turn up.
Covered Calls: If you see the market as neutral to negative, selling at-the-money covered calls can help protect against a mild downside while limiting your upside. As an example, you own shares of Amazon (AMZN) at $185 per share. You sell call options on your shares that expire in Jan 2012, and have a $185 strike price. These are worth $21.50 per share. If shares stay at the current price or rise, you stand to gain 11.62% in five months, or 27.9% per annum. Shares can drop down to $163.50 in five months for you to break even. Covered calls are similar to selling cash-secured Put options. The benefit of covered calls is that you give the share price a boost by going long in the equity market, and you are able to collect any dividends. The downside is that you need to perform two transactions instead of one and you run the risk of losing additional amounts in price slippage when buying.
U.S. Dollar: S&P downgrades, political squabbling, and the potential for more quantitative easing all add downward pressure on the U.S. dollar. Instead of creating a forex account for currency trading, you can also gain exposure through currency exchange based ETFs. For instance, by going long in the iPath JPY/USD Exchange Rate (JYN), you can profit if the U.S. dollar weakens against the Japanese yen.
When Will It End?
When will the market pain be over? It's hard to tell. If we are heading for another recession (and we are, in my opinion), then the bottom is a long ways off yet. In fact, the 700 lows of the S&P 500 from a couple years ago could be re-visited, and it could even go lower. As pressure is being put on governments to show spending restraint, it may not be the V-shaped bottom that we enjoyed the last time. It could mean a slow recovery as the average consumer pays down on debt to reach a more sustainable economy. In the meantime, while we cannot definitively say where the market will head, as so much rests on the sentiment and fear, these hedges and funds should provide a few alternatives if the equity markets are giving you heart palpitations.