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The markets have staged their biggest two-day drop since last August. Volume spiked during the decline, making it highest-volume back-to-back trading period since last June. The Russell 2000 led the selloff, dropping 5.25% from Friday's high to yesterday's low. Peak to trough, the
went fell 4.75% over the last couple of days, followed by emerging markets, which took a fall of 4.5%. Other major indices, including the
and the EAFE were off around 3%.
The million-dollar question is what's next for the markets? Many indices closed yesterday at their rising uptrend lines or their 50-day moving averages. If support holds, this little adjustment could be over. If the trendlines are broken, then we could see a 7% to 10% correction -- possibly even more.
We are at a crossroads of sorts. At these times, it becomes easier to be a defensive investor. If the uptrend lines are violated on a closing basis, especially on higher volume, then your long portfolio should either be lightened or hedged. A simple chart that has moving averages and the ability to draw trend lines is necessary to track this.
ETFs are excellent hedging tools. If you hold appreciated positions and do not want to create a tax liability by selling, determining which ETF is most closely correlated to your security is the first step for protection. The websites of most of ETF creators offer correlation tools. Calculating how many shares to buy is the more difficult part of this task.
A good way to make this determination is to review the price history for your security and the corresponding ETF. Use a calculator to determine relative price changes over the last one-year period or less. Do some math and make a best guess as to how many shares will adequately hedge your position.
Repeat this process for each position in your portfolio that you want to hedge. Recall that there 2-times and 3-times leveraged inverse ETFs that require less capital to effectively hedge risk on a long equity portfolio.
Though hedging can be effective, it is OK to sell to reduce risk or take profits. Should the support levels of the major indices be breached to the downside (signaling further decline), selling some long securities and purchasing inverse ETFs as a trade could allow traders to make money in both up and down markets.
Even after this quick drop, markets are still significantly overbought, and investors are far too complacent. The CBOE Volatility Index (VIX) was recently pegged at low levels not seen since the market top back in 2007. Meantime, the
iPath S&P 500 VIX Short-Term Futures ETN
has jumped 17% so far this week. Investors are finally waking up to the risks that exist in today's market. VXX is still extremely undervalued (should this decline continue).
VXX closed yesterday at $34.01and has a near-term price target of $38. Should the markets really get dicey, VXX could spike to $50 per share. Although it is quite a ways away, I'd suggest placing a stop at $29.25 for protection.
Many investors are more interested in maximizing return. As such, these investors rarely hedge or sell. They do well in bull markets and not so well in bear markets. In the long run, it is what you keep over a full market cycle that counts. Investing both offensively and defensively makes the most sense.
If the market rallies after you employ defensive measures, you pay the price through lost opportunity. However, if the markets continue to decline and you do nothing to hedge your positions, you could lose real money. I would forgo potential opportunity in order to protect real money every time.
Markets should provide a relief rally over the next couple of days. However, if the major indices close below yesterday's lows, that would be a sign that a larger decline has most likely begun. If the highs from last week are taken out, cover your short or hedged positions.
At the time of publication, Slusiewicz held no positions in the stocks mentioned.
Jerry Slusiewicz has over two decades of professional investment experience. He has worked with individuals and institutions to manage monies for both short and long-term investment horizons. This extensive experience through various stock and bond market cycles enables him to offer a unique blend of professional investment counsel and personal service.