The 4 Best Hedges for a Drop in the S&P 500

When stocks encounter a significant correction or long-term bear market, the writing is usually on the wall many weeks before. This was the case in the fourth quarter of 2015, in which red flags should have signaled investors to consider downside hedge protection. Prescient investors are being rewarded on a relative basis.

Many investors are averse to selling because of tax implications, but many lost 50% or more in their portfolios in the 2000 and 2008 bear markets, requiring a 100% gain just to break even. One way to reduce the tax bite is to offset profitable stock sales by selling losing positions. Raising cash does not have to be an all-or-nothing decision.

Jesse Livermore talked about "selling down to the sleeping level" when he worried about losses in his portfolio. If an investor is fully invested in stocks, raise cash to 20, 30, 40% or whatever feels necessary. Some choose to simply sell everything and wait for the smoke to clear. Another tactic is to place trailing stop-losses on stocks, so profits accumulate if the stocks continue to defy the broad market and go up. The stop-loss removes the position from the portfolio if it goes down.

There are a number of ways to hedge the S&P 500 directly. Investors can short an S&P 500 ETF, short S&P 500 futures, buy an inverse S&P 500 mutual fund from Rydex or ProFunds, or buy puts on the S&P 500 ETF or on S&P futures. Many retail investors are not comfortable or familiar with most of these strategies and often choose to ride out the decline and incur a large double-digit portfolio loss. One problem with the put option choice is that option premiums are pumped up with the increased volatility during a major decline, so an investor could be right on direction and still lose money. Selling short is probably not appropriate for an investor who is only casually involved in the markets.

In a full-fledged selling panic, investors utilize the flight-to-quality or flight-to-safety move into Treasury bonds or notes. The short end of the yield curve comprised of five-year notes or less often rallies the most, and this was the case in mid-February 2016 during a waterfall decline in stocks. It seems silly to follow the "herd mentality" into Treasuries as they are becoming overvalued, but it works if a trader has the sense to take profits along the way as equities begin to stabilize.

However, many long-term bear markets coincide with an economic recession, and in this case, the portfolio should tilt toward the long end of the yield curve by buying 10- or 30-year Treasuries. Of course, investors regret not having shifted to this orientation at the first red flag.

The VIX Index measures the market outlook for volatility implied by S&P 500 stock index option prices. Brutal market downturns almost always bring a surge in volatility, and going long volatility is a logical tactic. There are a couple methods to accomplish this, and the first is to buy VIX call options listed on the Chicago Board Options Exchange (CBOE). The calls normally rise along with the VIX Index, and it is important to select appropriate strike prices and maturity dates. A strike price that is too far out of the money, for example, accomplishes nothing, and the premium is lost. Be aware the calls are based on the price of VIX futures, and call prices do not always correlate perfectly with the index.

The second approach is to buy into the iPath S&P 500 VIX ST Futures ETN (NYSEARCA: VXX), but it is burdened with performance issues. This is an exchange-traded note (ETN), not an ETF, and like the VIX call option, it is based on VIX futures. This leads to some quirks, such as when VXX moves in the same direction as the S&P 500 16% of the time, though it is designed to move in the opposite direction. VIX calls are a better choice to hedge by going long volatility.

Market turbulence is part of the investing game and never goes away. When the storm is approaching, investors should arm themselves with effective hedges until better days return.