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Analysts are saying that there is a very real chance that a large European bank is going to go under; creating a financial crisis that will make the Lehman Brothers fiasco look like child’s play. The American economy is on the verge of heading back into recession, and virtually no one believes that President Obama has a plan to put the country back on track. Israel’s relationship with Turkey is on the rocks. The upcoming unilateral Palestinian declaration of statehood could plunge the middle-east into further chaos.

How can investors potentially profit from such financial Armageddons? I would like to focus on three approaches to both hedge and profit from a stock market drop.

Inverse ETFs

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 (NYSEARCA:SPY), he can either buy all 500 stocks, which would be very costly and time consuming, or he can purchase the 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 like SH and SDS 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 and also come in leveraged varities, enabling the investor to gain more bang for her buck. If an investor thinks that Obama’s proposed regulation will drive down shares of banks, she could choose to profit from the decline by purchasing an inverse ETF linked to the banking index (NYSEARCA:FAZ).

Volatility

Many professional investors like to look at market volatility as an indicator of future stock market performance. The VIX Chicago Board Options Exchange 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:

Investable VIX products could have been used to provide some much-needed diversification during the crisis of 2008 .... 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, such as VIXX, TVIX and XVIX. Keep in mind that investing in volatility is new for most investors and comes with risks. Investors need to take the time to understand how these products work.

Options

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.

Source: How To Profit From Financial Armageddons