All Defensive Strategies Come With Risks

My all time favorite market volatility Hedge Fund manager is Victor Niederhoffer (.pdf). Dr. Niederhoffer is famous for collecting premiums on massive amounts of short volatility options positions. Since 2001, his Matador Fund is reported to have generated over 40% returns every single year. However, the last month has seen the highest levels of market volatility during this entire period, and I can't help but wonder how Dr. Niederhoffer's short volatility strategy is holding up.

More importantly, I am concerned about my own portfolio, and how I can defend against this especially volatile market. Considering the myriad of negative news we've received over the last several days (e.g. bad manufacturing jobs data, Countrywide layoffs, overly quick rate cut assumptions by the market, and a variety of experts saying a re-test of market lows is coming), I've listed some specific defensive strategies to combat market volatility (particularly large downward market moves).

Some of the most basic strategies to combat market volatility include buying puts, selling calls, moving to cash, or just "riding out the storm." There are certainly advantages and disadvantages to each of these. For example, buying puts on the S&P 500 (SPY) might seem like a good idea, until Bernanke decides to cut the discount rate and the fed funds rates by 50 basis points each, which could easily render your puts worthless.

Selling SPY calls (for the premiums) can be less risky than buying puts, but they can also cause you to miss out on any big market gains. Similarly, moving to all cash can help you avoid market drops, but it can also cause you to miss out on big market gains. And "riding out the storm" (i.e. not doing anything) can be a good idea in the long run, but extremely painful in the short term.

People interested in more complex market volatility strategies can check out "The Education of a Speculator" by the famous Victor Niederhoffer- he really is a living legend!