February 28th: With the markets cautiously stepping higher today, it is apparent that a lot of people were burned in Tuesday’s sell-off and the appetite for risk that has driven the market higher over the last six months is missing, at least for the time being. I think trying to figure out what caused the market to drop so precipitously on Tuesday is a useless exercise, and the best we can do is to see what lessons can be learned.

The foremost message for everyone to remember is that investing carries risks. Sometimes the market goes up or down greatly for no discernible reason, and movements can happen faster than you can protect against. Rather than sitting and waiting for a crisis to happen before worrying about how to protect yourself from a decline in prices, you need to be proactive if you want to hedge risk. The worst time to decide to become risk-averse is when everyone has suddenly turned fearful. I know the people who started loading up on index put options immediately after the 3 p.m. “gap down” on the Dow not only lost money on those, but also on most of their positions they immediately started selling afterwards. Why? They were the ones who probably took on the most risk, and were now feeling the pain of having a highly volatile or leveraged portfolio. They blinked, and changed their own rules about what was acceptable to them based on the feedback from the market. If you are going to let market direction dictate whether you are right or wrong, you need to have a major mental rewiring. Know thyself; specifically, know thy own risk tolerance. This is an excellent time, in fact, probably the best time, to sit back and re-evaluate your risk tolerance. The market in the last several years has a had extremely low volatility, and the general upward trend has probably drawn more people into more risky positions than they should be in. I’m not advocating a withdrawal from any sort of “risky” play, like a small-cap, turnaround, or the like, but I think that with the ease investors today can hedge risk, there is no reason not to if you are concerned about volatility.

Two of the simplest ways to hedge risk is through the short selling of a related security, or through the use of options. While the normal reaction to such suggestions is something along the lines of “I thought I wanted to reduce risk?”, I would respond that both short selling and options can be used to reduce risk, if used the right way. Without getting into an overly academic explanation of risk and how to hedge it (we’ll save that for a later day), lets begin.

Our definition of risk will be “losing money from an investment”; there will be no fancy Greek letters or advanced statistics to figure it out. Hedging through a short position is made easy through the use of ETFs, especially with the many UltraShort ProShares ETFs that offer double inverse returns compared to their benchmark index. A tech-heavy portfolio holding stocks like Apple (AAPL), Google (GOOG), or a Nasdaq ETF (QQQQ) could reduce risk by approximately 30% by having 10% of funds invested in QID, the Nasdaq UltraShort ETF. Understand that mitigating risk will, however, limit returns; in the hedge-QQQQ-with-QID example, a 1% decline in the Nasdaq will likely cause this portfolio to drop by 0.7% - a 30% reduction in loss, but the opposing scenario of a 1% rise would only result in a 0.7% gain. Other common UltraShort ETFs to consider are DXD (Dow) or SDS (S&P 500), although ProShares offers many of these inverse levered ETFs for individual market sectors as well.

Another way to hedge risk is through the buying and selling of calls and puts. First, let me say that options are very complex financial instruments, and are not for beginners. For an experienced and well-learned investor, however, options offer tremendous flexibility in risk management. Selling covered calls (owning the underlying stock and writing a call option on your position) can help produce income and lower one’s cost basis for the stock, effectively reducing risk. Writing a covered call is not a very effective strategy to provide downside protection, however, because the underlying stock you own can fall all the way to zero, and the only money you would have left is the premium collected from selling the call. The more effective way to hedge risk with options is to buy a put, which will increase in value the more the underlying security decreases in value. If you own one put contract for every one hundred shares of a security, the maximum loss will occur if the underlying security closes at or below the strike price of the put on the expiration date, and the loss will be limited to the amount paid for the put.

I know this isn’t a very instructive tutorial, but more of an overview of ways to hedge risk. This will not be the last I write about short selling, ETFs, or options though, so I hope you stop back in the future when we have more information about hedging and the use of other financial instruments in portfolio management.