Hedge Your Portfolio With 'Ultra' Short ETFs

The recent stock market declines have a lot of investors thinking about how to layer in some defense into their portfolios. Just selling stock is problematic, however. Depending on the type of account, the sale could trigger a taxable event and generate a trading commission. Selling a stock you like is also difficult because if you are right about it, it might recover too quickly for you to get back in.

Of course it is possible that the recent market decline has revealed a weakness in something you own, in which case a sale might be warranted. But even middling stock pickers are unlikely to find that a lot of their holdings are actually bad companies.

This is where the short and ultra-short ETFs from ProShares can fill a void. I have written about these products here before and while they are not perfect, they can reduce your vulnerability to a market correction when used the right way. That's because, even if the long positions in your portfolio are dropping in price, the short ETF positions will keep the overall portfolio from dropping as much.

(Read here to find out why ETFs themselves are hard to short.)

Think of it this way: If the market drops 20%, but your account only drops 10% thanks to an ultra-short fund, does it really matter what the individual long stocks are doing? I submit that the result of the portfolio is more important than the result of any one individual component.

The obvious type of fund to use would be one that moves in the opposite direction of a broad-based index like the S&P 500 or one that tracks the inverse performance of a given index at twice the velocity; my preference is the ProShares Ultra Short S&P 500(SDS Quote) ETF, which meets both criteria.

Ultra-short funds provide more hedge for the buck. I think of them as a more efficient hedge than ordinary short ETFs and I prefer them to put options because you don't need to worry about expiration or changes in volatility.