​A Simple Approach to Portfolio Hedging with 2 ETFs

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The summer months are traditionally a weak time of the year for stocks, cautions growth and income expert Bryan Perry, editor of Dividend Investing Weekly.

When one looks at the market from a purely technical standpoint, the S&P 500 is running the risk of a material breakdown if its 200-day moving average suffers a protracted breach.

Because program trading dominates more than 70% of all daily activity on both the NYSE and NASDAQ, any high-volume, downside penetration of the 2,600 mark for the S&P will invite a 100-200 point sell-off for that benchmark index. Such an event could happen very quickly because of how these computer-generated sell programs can feed on themselves.

The current 200-day moving average sits at 2,615, with the next near-term level at 2,585, after enduring a February low of 2,550. However, those second and third levels are soft and will only act as speed bumps to lower levels.

chart 1

The problem I see is that, after three short breaches of this key line, a fourth breach could be a watershed event. Each rally attempt off this level has resulted in what chartists call a lower high.

The latest rally came just in the nick of time, but the market is a long way from being out of the woods. Since late February, volatility has been very elevated, and I don’t see that diminishing any time soon. So, an action plan should be considered if the market takes a turn for the worse.

For many investors, a go-to-cash exit strategy can create a nightmare of a tax situation. Instead, I recommend utilizing a sound hedging strategy to protect portfolios of all sizes.

This is a good way to mitigate downside risk in the event of a trapdoor sell-off where stocks drop like they are going over a waterfall. We all know the old saying, “if you fail to plan, you plan to fail.” Nothing could be truer than when it applies to our money in a frothy market.



Seeing how headline risk has played havoc with the major averages on so many trading days this past couple of months, I find it incredibly naïve of investors to not have a plan for portfolio insurance in place.

As to what most investors can lay on in the form of portfolio insurance, I would look to a few potential instruments. They are the ProShares Short S&P 500 ETF (SH) Trade and the iPath S&P 500 VIX Short-Term Futures ETN (VXX) Trade.

This two-part portfolio hedge lets investors short the S&P 500 in an unleveraged exchange-traded fund (ETF), while playing the upside spike in market volatility if the S&P 500 tops its key 200-day moving average in a material way.

This approach is a very simple way to insulate a certain measure of downside risk. Everyone has portfolios with varying degrees of risk and, therefore, has to determine what percentage of a portfolio should be weighted in hedging instruments versus long exposure and cash.

Bryan Perry is editor of Dividend Investing Weekly.

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DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
vxx iPath S&P 500 VIX Short Term Futures TM ETN
SH ProShares Short S&P500 29.38 0.08 0.26 1,440,823

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