In the immediate aftermath of the Japanese earthquake, uncertainty and volatility reigned, both for the people directly affected and investors, too. For the latter, it was a powerful reminder of portfolio risk management and the typical response to a crisis. Many people whose portfolios weren’t adequately prepared for the shock let their emotions rule and engaged in a furious bout of panic selling. However, there are some simple ways to cushion the blow when markets turn against you…
Shock Absorber #1: Trailing Stops
We’ve all been there. You buy a stock and its value quickly rises. Then it begins to decline. What do you do? Buy more, let it ride, or sell?
Save yourself a lot of pain and agony by following a simple rule: If a position ever falls by more than 25% from its high, sell it immediately and reassess the situation.
Why 25%? Because this sort of decline typically indicates that the fundamentals have broken down and it’s time to exit. However, if your risk tolerance isn’t as high, you can set a tighter stop at 10% to 20%.
Shock Absorber #2: Hedging Your Risk With ETF Put Options
Two of the fastest-growing markets over the past few years are exchange-traded funds (ETFs) and options. And today, roughly 40% of ETFs have options available that you can use to hedge your risk on positions.
Many ETF investors are unaware of this, though.
To see if options are available for a specific ETF, just go to Yahoo! Finance and enter the ticker symbol. On the left side, you’ll see a menu. Just click on the “options” link and if options are available, they’ll show up.
One of the simplest ways to use options for downside protection is by buying puts to hedge against long ETF positions. For example, you could take out what I call “China insurance.”
Suppose you think the Chinese market will rise, but you’re uncomfortable with the downside risk that also comes with investing there. You could do two things…
- Invest in a China ETF like the iShares FTSE China 25 Index Fund (NYSE:FXI) or select some individual Chinese ADR stocks.
- At the same time, you could purchase a put option on FXI, with an expiration date in January 2012 or 2013. The cost of this is the “premium,” which will depend on the “strike price” you choose.
Doing this ensures that you’re positioned to profit from upside on the Chinese stocks or FXI, while also having the put option to cover against any losses.
If you’re new to the options world, however, be sure to do your homework before jumping in. In our Investment U archives, we’ve got a ton of educational material and “how to” articles on various options strategies.
Shock Absorber #3: Inverse ETF Hedges
Speaking of ETFs, there are funds that move in the opposite direction to the indexes/sectors that they cover. These are known as inverse ETFs.
For example, if you strongly believe that emerging markets are overvalued, you could play that theory through the ProShares Short MSCI Emerging Market ETF (NYSE:EUM), which moves in the opposite direction to the MSCI Emerging Market index.
There are a plethora of inverse ETFs available on a wide range of areas, such as oil, gold, Treasuries and currencies.
Shock Absorber #4: Cash Can Be King… But Use it Wisely
Many investors have a hard time holding too much cash in a portfolio. In order for the portfolio to grow effectively, the cash needs to be put to work. However, it’s a lot smarter to invest gradually, rather than toss it into the market at once.
Likewise, shifting to 100% cash in your portfolio is almost always a blunder. But in a sharp market downturn when your positions hit their trailing stops, it’s wise to replenish your cash reserves and then follow a calm plan to put it to work.
Employ these four “shock absorbers” in your portfolio and they’ll help you manage risk better and avoid panic selling.