Use ETFs to Protect Yourself From a Pullback

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

By David Gillie

NEW YORK ( ETF Digest) -- Don't panic -- just be prepared.

Pullbacks are a healthy function of the market. They allow new investors to come into a rising market and signal profit-taking for smart money.

Timing a pullback and protecting your portfolio is of the utmost importance. What you don't want to do is sit and watch your portfolio's value sink. So, first let's look at timing a pullback.

Directional changes frequently occur at the intersection of trend lines as you can see in the chart below. The upper channel (green dashed line) intersected the long-term trend (blue dashed line) at the end of October, and the long-term trend line intersected with the mid channel (orange dashed line).

By projecting outward at the current trajectory, we see that the upper trend line (blue dashed) is about to intersect the lower channel line (red dashed) in the next few days.

A trend-line cross above the price is more predictable than a trend-line cross below the price. It is possible for this formation to result in an explosive move upward in price.

To anticipate better directional price movement at the intersection, we have to look deeper into present conditions.

During the first week of 2012, the price of the S&P 500 stalled at the price resistance level around 1280 (green horizontal line). We broke through this price resistance this past week but stalled again.

Friday's price action formed a hammer candlestick, typically a bullish formation. However, in this case, it's a red hammer, which often fails. Additionally, the tail of the candlestick pierced support, indicating weakness. Weakness was confirmed by the light volume. This gives us two bearish conditions on a bullish candle stick. Not encouraging.

Mid channel support/resistance (orange dashed line) is an often overlooked inflection point in technical analysis. We can anticipate the price of the S&P to hit this level around 1310.

That should also coincide with the intersection of the upper trend line and lower channel line as described above. Also, throw options expiration on Jan. 21 into the mix. Options expirations tend to throw the market into a tizzy. The middle of next week is likely an inflection point. OK, that covers timing.

Now let's look at how we protect our portfolio. First and foremost, don't leave profits on the table. Remember, you can always buy something back again if you jumped the gun, but you may not be able to sell (at this price) again if you missed the move.

Or, let's put it another way: Nobody ever went broke taking a profit. We have two events to signal profit-taking forming: 1) Price hitting mid channel resistance; 2) trend-line intersection.

You may not necessarily have to capture the last dime of this recent move. Even if the market continues up after you take profits, you'll still have your initial investment in to continue the move.

Now we move to the next level of protecting your portfolio and even profiting by a pullback.

There are numerous ways to accomplish this, but let's look at the most simple way via long-term Treasury ETFs. Treasuries tend to move in an inverse correlation to equities.

Therefore, we're going into a "long" position as opposed to the much higher risk of shorting.

We are not seeking yield from Treasuries, but rather a short-term capital gain.

There are two ETFs that will best accomplish this goal: iShares Barclays 20+ Year Treasury Bond ETF ( TLT) and the leveraged version of that ETF, the Direxion 20+ Year Treasury 3X ( TMF).

Treasury ETFs tend to be the most "forgiving" of the hedging positions if you don't time your hedge just perfectly.

Another inverse correlation to equities is the Volatility Index. Traders will sell calls and buy puts for downside protection. This causes the VIX to rise. Again, rather than shorting, we can take a long position in the VIX.

There are two established levels of the VIX that we watch closely.

The first is 30 (green horizontal line). Levels greater than that generally indicate fear in the market.

The second is 20 (red horizontal line). When the VIX falls below that level, the market is considered to be complacent. We just took a second bounce off the important 20 level and moved up this week.

When the VIX moves, it goes up much faster than it goes down. Therefore, you need to be in your position before the move.

Also, the VIX may make the majority of its move over a relatively short time, maybe just a week. Over the past six months, we've seen very unusual levels on the VIX.

Barring a collapse in Europe or war in the Middle East, the VIX would likely move up to 30 as a norm. There are several ETFs that track the VIX, but we'll look at just two, the most heavily traded issues.

The iPath S&P 500 VIX Short Term Futures ETN ( VXX) has an average daily volume of more than 18 million shares. This is a very liquid position and closely tracks (not exactly) the VIX.

You could also consider the leveraged issue, VelocityShares Daily 2x VIX Short Term ETN ( TVIX), which has an average daily volume of 3.6 million shares.

If you take a position in one of these VIX ETFs, it would be prudent to set your sell price to correlate with 30 on the VIX. Some brokerages will actually allow a conditional order to place the sell trigger on another equity or index.

Overall, the U.S. economic data have been somewhat better. Not great, but good enough so that there doesn't seem to be a sense of fear or panic in the market. This is why we are not expecting a major selloff or a radical spike on the VIX should we see a pullback.

You may recall an article I wrote on TLT with two New Year's resolutions:

1) Don't leave profits on the table

2) Hedge

Since you've probably already broken your diet and exercise pledges, there's still time to keep your new resolutions.

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This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.