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In times of volatility, becoming a hedge hog may help you build your long-term portfolio. Assume that:
  • You are long the stock market and have a lot of great stocks in your portfolio.
  • You think the market will head higher within your investment time horizon (if you don’t think this, why are you still long in the market?).
  • There are some additional long term investments that you would like to own, or some you would like to add to.
  • Markets are exhibiting volatility, going up and down large percentage amounts on a daily basis.
  • You would like to have something to off-set a downward movement of the prices of your stocks.
You make a list of “risk on” assets that you would like to own. For example, let’s say that you are interested in emerging market ETFs like Vanguard’s Emerging Market ETF (NYSEARCA:VWO) or business growth sensitive commodity stocks such as Petrobras (NYSE:PBR), Rio Tinto (NYSE:RIO) or VALE — investments that have tended to go up when investors expect global expansion and have tended to go down when those same investors become risk-averse. You might choose other stocks or sectors. From the stocks that you would like to own, you create your potential Buy List. You also make a list of ultra inverse ETFs that usually move up when the markets move down, like ProShares UltraShort S&P 500 (NYSEARCA:SDS) or ProShares UltraShort MSCI Europe (NYSEARCA:EPV). You can keep these two lists on SeekingAlpha.com as sample portfolios.
Let’s try an example of what might happen during a volatile market. Let’s say that on Day 1, the world appears rosy, the market weather is sunny and bright, and the market is smiling. Not surprisingly, many of those emerging or frontier ETFs and industrial commodity stocks are expensive, and getting more expensive. On the other hand (hopefully), some of those ultra inverse ETFs are cheap, so you buy one or more ultra inverse ETFs that short the markets (for example, EPV) and set your Stop Loss or Stop Loss/Limit Orders (“Stop Orders”). Without the protection of stop orders, you can lose a lot and lose it fast using ultra ETFs.
Day 2, version 1. Oops! The market keeps going up. Your Stop Orders are triggered. Your “insurance” was not needed and you lose 5% or whatever your stop order was set at. But, because the market went up, your other investments probably did fine.
Day 2, version 2. But let’s say instead that Day 2 is a “sky is falling” day, that the market goes down, and your inverse ETFs go up (hopefully). Meanwhile, the prices of some of the stock on your list of emerging market and commodity miners have gone down. You sell your inverse ETFs and buy some emerging market ETFs or commodity miners, or whatever stock you have on your buy list. Now, if the market goes back up you can sell your “risk on” stock, or as I prefer to do, hold it for the long-term.
In other words, on down days, I use this strategy to find some of the money that I need to buy the stocks that I want to own for the long term. Of course, if the market keeps going down, the value of your new stock will probably go down also. This has happened to me sometimes. No one can predict the top or the bottom of the markets, or their direction. But at least, perhaps, you reduced your losses and gained some good stock for the long haul.
Disclosure: I am long EPV, RIO, PBR.

Source: Becoming A Hedge Hog