Using Leveraged ETFs to Hedge Market Volatility

Includes: QID, SDS, SPXS, TZA, VXX
by: Hedge Fund Trader

Today’s market is all the talk, no matter where you go or what you are doing. I’ve had college interns ask me the best way to buy gold (usually a sign of a top, but in this case I think we have a little more room to the upside), and others asking what stocks I recommend after a huge sell-off (AAPL, GOOG, AMZN). At this stage, I would encourage people to try to get a portfolio that is market neutral. What does that mean? Investing in equally long and short positions by using leveraged ETFs.

A few notes about ETFs (though most readers are already familiar): ETFs are investments, much like stocks. An ETF can hold assets such as stocks, commodities, or bonds, and is open during normal trading hours. Most ETFs track an index, such as the S&P 500 or NASDAQ. Others have been leveraged and are rarely worth the long-term investment - but I believe that in today’s volatile market, they can be used as an excellent hedge. Take for instance the 2X or even 3X ETFs. These products can be bought as long or short positions with returns double and triple the averages.

Normally, I would not recommend such strategies as the risk/reward is magnified. For example, if you were long the Small Cap Bull 3X (NYSEARCA:TNA) over the last month, you would have lost over 50% of your investment. I can’t stress this enough. These are very volatile strategies and should be rarely used. However, I find that this particular market environment is a perfect time to implement such a strategy. I recommend maintaining your current positions at present, while using limited capital in a leveraged ETF to cover your potential losses on more downside.

Friday’s close at lows didn’t show much hope heading into the weekend. I believe that we will re-test the S&P 500 lows of 1100 and in a worse-case scenario, see downside of 1025. Based on Friday’s close, the 1025 level accounts for another 10% correction, adding to our already beaten down returns. This level was last visited in June of 2010. I’m not saying that we will make it there necessarily, but the market action is certainly making it seem possible.

In order to prepare for the worst, I recommend looking at the Small Cap Bear 3X (NYSEARCA:TZA), Large Cap Bear 3X (BGZ), UltraShort QQQ (NYSEARCA:QID), or UltraShort S&P 500 (NYSEARCA:SDS). In order to become market neutral with 3X ETFs, you need to buy about 1/3 of your total long portfolio. Be aware that this will not be an absolute neutral cover, but something nearly close to protect yourself from all the market noise over the following weeks and maybe months.

As market volatility drops over time, I would consider selling these ETFs. I’ve been following the S&P 500 VIX (NYSEARCA:VXX) as a good barometer. Before the market's down-move, the ETF was trading around 18-20 and has doubled to 42 as of the close on Friday. This should begin to drop as the market finds a place of equilibrium. Look for a return to the low 20s or even teens before selling your positions.

During tough global market conditions and recession talk domestically, it’s best to find a comfort-zone by managing your risk. Opening these ETF positions can be an excellent hedge and provide a good night’s sleep without the daily fluctuations in your investment portfolio.

Disclosure: I am long AAPL, GOOG, AMZN.