Best Hedges For An Uncertain Market

Includes: DBC, JYN, SPY
by: Elite Wealth Management

By Fariba Ronnasi, CEO, Elite Wealth Management

The S&P 500 has swung down -10% and swung up 6% in a little bit of a rollercoaster ride over the past couple of weeks and volatility as measured by the CBOE VIX Index peaked above 25 over a week ago as investors scrambled for some kind of direction. The ongoing geopolitical concerns, depressed commodity prices, Ebola scares, and economic slowdowns appear to have finally halted the bull market’s advance. It's not yet certain if the recent reversal back up will reverse course again and go back down or continue to jump up on positive earnings and bullish Fed sentiments.

It could also be the beginning of an economic downturn and the start of a bear market cycle. Even positive news from earnings reports can be partially attributed to artificial means like stock buybacks and accounting manipulation.

While many investors panic, others are calmly assessing each possible scenario with a cool reserve. No one on Wall Street, even Warren Buffet himself, is a true oracle that can foresee the future but it's their strategies that help them maintain under pressure.

The secret is simple – portfolio hedging. Even confident investors engage in hedging strategies to manage their risk better. Trading in a volatile market with multiple downside catalysts means that extra precautions should be taken.

It's the kind of trading environment where hedge funds shine. While many such investment companies have aggressive, un-hedged strategies nowadays, these financial engines were originally known for their ability to protect against downturns. The title “hedge fund” was so named because it was designed to make money in all market conditions, up, down, or sideways, while delivering risk similar to or better than the overall market.

Hedging Your Bets

It isn’t difficult to cover yourself in the event that your expectations don't happen exactly as planned. While some strategies can be complex with multiple legs, many more are relatively easy to set up and apply to your investment portfolio.

The easiest way to hedge your stock portfolio is to utilize options. As long as you buy or sell in round lots, 100 shares, you can use various options techniques to protect yourself from lossed. Other methods include taking advantage of alternative asset classes that aren't positively correlated with stocks such as commodities.

Considering how poorly commodities have fared lately, they may be undervalued and primed for a rebound, especially in light of what’s happening in the equity markets. Bond prices are traditionally negatively correlated with stocks and could be a safe haven for investors as well.

There are a number of risks in the market right now though and no single hedge can completely protect your portfolio. From falling oil prices to possible rate hikes, every market should be carefully evaluated and hedged against.

The Sky Is Falling Hedge

A stock correction isn't anything new, but it always seems to take financial markets by storm. The best time to hedge your portfolio isn't after the floor falls out from under you, but rather the moment you initiate a trade. And when you want to protect yourself in a stock portfolio, the best answer is with options.

In August of this year, infamous short speculator and hedge fund magnate George Soros plunked down $2.2 billion, or 17% of his total assets under management, in put options on SPY, the SPDR S&P 500 ETF.

His portfolio is still long overall though. His fund holds hundreds of stocks that he thinks will profit over the long term. His short position was just a way of making profits during a declining market which also serves to protect his overall portfolio of long positions.

Here's a list of some option hedging strategies that you can use to protect your portfolio:

  • Covered Call – To set up a covered call, all you need to do is sell a call on a stock that you have bought long. You get a credit for the trade which lowers your cost basis at the risk of having to sell your stock should it rise up to the strike price by expiration.
  • Married Put – A married put is where you buy a put option along with buying a stock long. You still have all the upside potential, but complete downside protection should the stock drop before expiration.
  • Zero-Cost Collar – This strategy is best used when you're already up on a stock and you just want to lock-in profits. Assuming you already own the stock, you then sell a call and use the credit to purchase a put. Like the name implies, this method provides complete downside protection and can be done for no additional cost at the expense of possibly selling the stock if it goes much higher.
  • Long Straddle – This option play combines buying both calls and puts in order to take advantage of price movements in either direction. This is mostly a volatility strategy that profits when prices move quickly. Loss occurs only if the stock stays within a certain price range and doesn't rise or fall as much as expected.

Using Commodities

Equities and options aren't the only way to hedge yourself in the current environment. Commodities like oil, precious metals, corn, wheat, and other items trade more on the fundamentals of supply and demand as well as meteorological events and geography. As a result, commodities don’t have a strong correlation with stocks but have a slight tendency towards an inverse correlation.

Compare the path of the S&P 500 and PowerShares DB Commodity Tracking ETF (NYSE:DBC) since 2007.

Note the spike in the Commodity Tracking ETF in 2008 while the stock market trended lower. You can see the disconnect that's been forming in the two indices since the beginning of 2013 with the S&P 500 pulling away from the ETF. That disconnect could be a signal to get into commodities as a contrarian play as well as a hedge play.

Commodities are often used as a hedge against inflation as well. While most asset classes don't hold up well against steadily rising inflation, commodities track well with it. With the threat of rising rates next year and the possibility of inflation on the horizon, commodities might be a good place for investors to ride out market volatility.

The Bond Market

As most investors know, bond prices are inversely correlated with stock prices. That is, bonds fall when stocks rise and vice versa. With the rising volatility in equities and threats of a global slowdown, bonds may offer investors a safe haven.

The safety of bonds though may be only temporary. Interest rates are expected to rise in 2015 which will negatively impact bond prices sending them lower. Considering that interest rates are at historic lows, there doesn't appear to be much upside potential for this market.

However, the bond market’s value as a safe haven against volatility could drive prices higher in the short term. Investment-grade corporate bonds issued by financially sound companies could provide a temporary hedge against falling stock prices.

Short-term bonds should see a small boost over the next few months, but longer-term bonds are ill-advised. The looming rate hike will impact long term issues hardest and there may be a lack of buyers in the bond market when investors try to sell. This would impact liquidity and further drive the market lower.

Final Thoughts

While there is no such thing as a perfect downside scenario, there doesn't seem to be too many catalysts for driving the market up from this point either. As global economic concerns grip investors, the U.S. is traditionally the first place to seek out opportunities but it doesn't appear to be happening that way this time.

A quick look at the U.S. dollar to Japanese yen chart reveals that the yen is actually strengthening against the dollar. This means that money isn’t moving to the U.S. as we would expect. The U.S. dollar has been strengthening for most of the year but has started to pullback over the past couple of weeks. Whether it’s just the result of simple profit taking or a signal of a larger underlying problem, isn't yet known.

The massive bond buying program of “Abenomics” should be diluting the yen against the dollar but this is not happening. It's strengthened over 3% at the October lows and is causing some concern for investors.

Investors should keep an eye on a number of factors to determine whether this correction has legs to keep going or ended up being overblown. These are the top issues right now:

  • U.S. Dollar exchange rate compared to the yen and euro.
  • Inflation reports and interest rates
  • Corporate earnings
  • Volatility
  • Fed actions

These 5 factors are what will guide the market’s performance up to the end of the year. Any long position should be appropriately hedged – options to equities, commodities to inflation, bonds to equities, and commodities to currencies. A simple rule of thumb is the order and correlation of stocks, bonds, commodities, and currencies:

Currencies up, Commodities down/Bonds up, Stocks down

No one single asset class will provide adequate protection in the current state of affairs. Investors should diversify more than ever to hedge against risk while still positioning themselves to profit from long term positive fundamentals.

Disclosure: This article is not intended as investment advice. Elite Wealth Management or its subsidiaries may hold long or short positions in the companies mentioned through stocks, options or other securities. Read our full disclosure here.