For 2009, Insulate Your Portfolio

More advanced investors may consider buying options on the above hedges instead. The capital required is a lot less, and the impact can be just as meaningful. I can't stress enough that the goal here is hedging, not speculating. As such, I would recommend buying in-the-money puts on SPY or in-the-money calls on SDS or DXD in order to maintain the goal of hedging. The markets have been extremely volatile, meaning that options' prices -- especially those on the whole market -- contain absurdly high time value premiums. Because the purpose is to hedge, buying deep-in-the-money calls or puts minimizes the time premium paid and also requires less upfront capital than buying the outright instrument.

So, for example, if an investor feels that the S&P is still due for a fall before getting truly cheap, he or she could buy a call option on Ultrashort S&P 500 index. The value of this instrument today is $86 per share. For the S&P to reach 700, the markets would need to decline almost 20% from today's levels. Because the SDS performance is twice the inverse, that would represent a near 40% increase, or a share price of $120.

You can buy a March 2009 $60 call option for about $30 a contract. You could initiate a 5%-10% position, and if the index declines, say, 10% between now and March, the shares would be trading at about $103, or up 20%. The $60 calls would be worth $43, or a 43% gain. If you had 10% of your portfolio's assets in this position, that would represent a 4.3% gain. Assuming your long positions declined with the market, you be down a net 5.7%. If the market did decline by another 20%, SDS would trade at $120; the calls would be worth $60, a 100% gain. A 10% position would boost your returns by 10%, a very meaningful offset to a 20% market decline.

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At the time of publication, Gad had no positions in stocks mentioned, although positions may change at any time.

Sham Gad is the managing partner of the Gad Partners Fund and the Gad Partners Offshore fund, value-centric investment partnerships based in Athens, Georgia. Gad has written extensively for the Motley Fool and was a securities analyst for UAS Asset Management, a small, value-focused fund in New York City in 2007. Previously, Gad managed assets for the Gad Investment Group. For additional information, please visit www.gadcapital.com.

Gad also runs a value-investing blog inspired by the teachings of Benjamin Graham and Warren Buffett. Additionally, he is currently working on a value investing book to be published by John Wiley & Sons in the fall of 2009. Gad earned his BBA and MBA at the University of Georgia. Send Sham Gad an email. You can reach Gad at [e-mail].