There are many ways to hedge your portfolio against a market correction. However, there is one that I have discovered myself and has saved me during the correction times in 2010.
Before I start explaining about my method, let me review the most widely used methods and their drawbacks:
1) Buying puts: This method is useful if you buy the right put option (right strike price), at the right time, and with the right amount. With this method, time is your main enemy as the options decay so quickly. So, many of the times, not only you lose money on the stock you own, but also you will lose on the put option you bought as it does not surpass the strike price for example.
2) Shorting the index or stocks: This method doesn't have the time decay problem of method one. However, 1) You are exposed to unlimited loss, 2) There are usually high margin requirements to short stocks, which may make it an inefficient method, 3) Market volatility may cause your position to be closed automatically by your broker, and 4) Your account may not allow you to short (Such as RRSP accounts in Canada)
3) Buying inverse ETFs: Most of the inverse ETFs are leveraged ones. It is well known that these ETFs have time decay plus some hidden ETF fees (look at SRS or FAZ for example). Even worse, the leveraged ETFs require a very higher margin requirement which again makes them inefficient. There are non-leveraged short ETFs too that may work better, which I don't have much experience with. But even those look to have inconsistent performance over a long period of time (look at the chart comparison of SEF and XLF for example)
The above methods are not necessarily wrong approaches, but due diligence is needed in using them.
Before I explain my method, I would like to draw your attention to the following chart overlay:
It is the long term overlay of the S&P 500 index with CAD/USD (FXC) chart. What shows to be interesting is that the Canadian dollar (to USD) trend follows the same trend as the S&P 500 index. When the index goes up, Canadian dollar also trends up; when the index goes down, the Canadian dollar goes down. So, what is the idea?
The idea is: Instead of shorting the market, one can buy USD/CAD in the forex market. What are the benefits of this method?
1) Leverage: Most of the forex brokers give a very good margin to do forex trades. For example, to buy $40,000 USD.CAD, you only need $1000 in your account. Of course, you have to leave enough cash in your account to avoid margin calls.
2) More freedom: As forex is traded internationally, you can trade forex outside of stocks trading hours giving you more time flexibility.
3) Bottom line: If you buy USD and the value drops: 1) Most probably your stocks (or your index investment) will go a lot higher, 2) It's money! You can keep it and use it to buy cheap merchandise priced in USD, or use it later on when you travel to the US. I don't mind owning USD for long term, but I do mind owning an inverse ETF for long term.
The next question is how to design the portfolio to have enough protection. I will discuss it in future posts. Your comments and thought are welcome.
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