How to Outperform the Market and Manage Risk With ETFs

So if you want downside ("synthetic" short) exposure to the S&P, you can buy the Short S&P 500 ETF. How does the short ETF work? Simply put, as the S&P index declines, the Short S&P 500 ETF rises. As the S&P rises, the Short S&P ETF declines.

What is so powerful about these inverse ETFs is that they do not require a margin account. But the ETF world did not stop there. ETF companies have also created leveraged ETFs to get you double exposure to an index, such as the S&P. The leveraged ETFs are available in both the long variety, such as the ProShares Ultra S&P 500 (SSO Quote - Cramer on SSO - Stock Picks) and the short variety, such as the ProShares UltraShort S&P 500 ProShares (SDS Quote - Cramer on SDS - Stock Picks). These leveraged ETFs can only be traded in cash accounts and eliminate the need to trade on margin. However, be forewarned, with these leveraged ETFs, you can lose money twice as fast.

How I Manage Risk With ETFs

Here is one risk management method which I have employed in the past and plan to use again. Say you are 100% long in your account. You want to move to a more neutral position. Take the following actions:

1. Sell 30% of your portfolio. When I say 30% I do not mean 30% of the market value . I mean 30% of the beta value of the portfolio (see "The Finance Professor: Manage Risk Like a Pro"). You can achieve this by selling 30% of each position or carefully vetting out individual positions to arrive at this goal.

You should now have a portfolio that is 70% invested and 30% in cash. 2. With the sale proceeds, buy the UltraShort S&P500 ETF. By using 30% of your risk capital to buy the "ultra-short" ETF, you have now created twice that amount (60%) in downside exposure.

You should now have a portfolio that is only 10% exposed to the market. Please note: the exposure may vary by portfolio due to individual beta calculations and tracking errors. A tracking error is the difference between the actual performance of a portfolio and the benchmark index which it is designed to imitate.

3. Monitor the market. Once the market has corrected, you can sell your ultrashort hedge and redeploy your capital back into the market.

For quick reference, below is a table which lays out the ETFs in various forms for the major U.S. indices:

                                                                                                                                                                                         

Index	Corresponding ETF
	Long	Long Levered	Short	Short Levered
S&P 500 (SPX)	SPDR Trust (SPY)	Ultra S&P 500 (SSO)	Short S&P500 (SH)	UltraShort S&P500 (SDS)
Russell 2000 (RUT)	iShares Russell 2000 (IWM)	Ultra Russell 2000 (UWM)	Short Russell2000 (RWM)	UltraShort Russell2000 (TWM)
S&P 400 MidCap (MID)	MidCap SPDRs (MDY)	Ultra MidCap 400 (MVV)	Short MidCap400 (MYY)	UltraShort MidCap400 (MZZ)
NASDAQ 100 (NDX)	PowerShares QQQ (QQQQ)	Ultra QQQ (QLD)	Short QQQ (PSQ)	UltraShort QQQ (QID)
Dow Jones Industrial (DJI)	?DIAMONDS? Trust (DIA)	Ultra Dow30 (DDM)	Short Dow30 (DOG)	UltraShort Dow30 (DXD)
S&P 600 SmallCap (SML)	iShares S&P SmallCap 600 Index (IJR)	Ultra S&P SmallCap600 (SAA)	Short S&P SmallCap600 (SBB)	UltraShort S&P SmallCap600 (SDD)

ETFs have a variety of uses and come in many different forms. This lesson outlined two interesting ways you can use ETFs as part of your risk management and overall investment process. In the future, I will present other techniques for managing your portfolio with ETFs. In the meantime, if you are looking to reallocate a portion of your assets or go to a more neutral market stance, consider using the strategies I outlined above.

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