Everybody loves a market that can’t do anything but go up. That’s what we’ve had over the past few years but what comes up will eventually go down. You can either take the ultra long term approach and ride out the waves that inevitably arrive or you can take out some insurance to protect yourself. Investors call it hedging.
Insurance in the investment markets isn’t the same as auto, health, or life insurance; it’s a type of investing strategy that loads your portfolio with assets that will do well when markets take a nosedive. Here’s how the pros do it.
Have you ever heard the phrase, “flight to safety?” Some say, “flight to quality” but it’s essentially the same thing. When markets get scary, investors sometimes pull their money out of stocks and put them in bonds, treasuries, or cash. Other times, they might pull them from high volatility stocks like the tech sector and put them into more stable sectors like healthcare and utilities.
Normally, when you purchase stock, you make money when the stock rises in value but what you may not know is that you can “short-sell” stock so that you make money when the stock falls in value. This gets rather complicated but it involves borrowing shares from somebody who already holds them. You have to continually pay for the privilege of borrowing so shorting stock is only good for short term hedging.
The options market was once this exotic place where only the most advanced traders tried to make money but today, it’s soaring in popularity. When you purchase options, you’re not purchasing stock; you’re purchasing the right to buy stock at a certain price during the contract period. Call options tend to rise in value when the underlying stock rises and put options tend to make money when the underlying stock falls in value.
By purchasing put options against stocks or ETFs you already own, you can lessen the sting of a falling market because your put options rise in value as your stock falls. This is another strategy that is more for the advanced investor but you can start reading up on it here.
Probably the easiest way to hedge your portfolio is to run for the hills. By moving some of your money to cash, you protect it from any downside moves. Once the market stabilizes, you can re-deploy it. Professionals use this strategy frequently. Consider taxes. Any time you sell for a profit, you trigger taxes when it’s outside of a tax advantaged account.
For beginning investors with a long-term time horizon, don’t panic when the market takes a dive. It’s normal. If history is a guide, it will eventually recover and so will your portfolio. If you’re a shorter term trader, learn about hedging and how to protect yourself against big market swings. Played correctly, a volatile market can be a trader’s best friend.