Ways To Get Downside Protection With Dividend Stocks

Nilus Mattive
updated | Author's Website

In the meantime, consider …

The Inherent Relative Safety That Dividend Stocks Provide …

It’s a fact: During weak markets, shares that pay dividends tend to hold up far better than their non-paying counterparts.

In 2002, the S&P 500 broad stock market index fell 23 percent. Shares of non-payers in the index fell 30 percent. And the dividend-payers dropped just 11 percent.

In 2008, the worst year for stocks since the Great Depression, the same general trend held yet again. Dividend stocks outperformed non-payers by roughly six percentage points.

And that’s just speaking in generalities … a well-chosen list of dividend stocks can do even better.

For example, the sum total of my dividend stock recommendations (open and closed positions) has outperformed the broad market by about 33 percentage points over the last three years!

Plus, even if you own all dividend-paying shares, there’s an additional way to protect yourself from taking a loss on your initial investment …

Stop Losses: What They Are and When They Make Sense

A stop loss order tells your broker to sell your shares should they reach a predetermined price level.

For example, if stock XYZ is trading at $10 a share, you might give your broker a stop loss order of $8. Then, if XYZ hits that level, it will automatically be sold at the best price possible.

Please note that I did not say it will be sold at $8! While stocks with a lot of liquidity should get unloaded very near a stop price, there is the chance that the market will move down so fast that your order will get filled at a lower price than you specified.

Some folks learned this the hard way during the market’s recent “flash crash!”

To alleviate that risk, you can also place a stop limit, which is a very specific order telling your broker what range of prices you’re willing to accept.

Now, I do NOT recommend stops for your long-term, income-generating investments, provided you believe the company is strong and the dividend is reasonably secure.

That’s because if you’re constantly getting stopped out of positions, you will lose the current income, which is the real benefit of buying and holding dividend stocks.

However, choppy markets call for defensive measures when it comes to your shorter-term positions, especially if capital appreciation is the main goal.

You can also employ stops in your profitable positions as a way to lock-in gains in the event of a market decline. Simply raise your stop loss as the profits pile up.

And If You’re Looking for Short-Term Hedges, Inverse ETFs Are Worth Checking Out

Like other exchange-traded funds, inverse ETFs hold a basket of investments but trade under a single ticker symbol on a major U.S. exchange. Think of them as mutual funds that you can easily buy and sell. They generally carry low expenses, too.

But the “inverse” part means that instead of moving up and down with the markets, they do the opposite.

So, an inverse ETF focused on Dow stocks should go UP when the Dow goes DOWN by roughly the same amount.

There are also double and triple inverse ETFs. They can be expected to go up two to three times as much as the Dow or another index goes down.

If you’re an income investor holding dividend stocks, inverse ETFs can help you hedge your portfolio against an imminent market drop without having to lose ownership or miss out on any dividend payments.

That’s not to say there aren’t some disadvantages with inverse ETFs:

First, you must allocate some of your investment dollars to the inverse ETFs, thus giving up some income for the protection.

Second, if the market rises substantially, your inverse positions will lose money (or at least offset the gains in your “long” positions).

Third, because of the way they’re constructed, inverse ETFs can drift away from their benchmark over time. And this is especially true of the double and triple leveraged versions.

In other words, if you hold them in your account for a long time, you may find that they gradually move away from the “mirrored” performance you expected.

But for short-term purposes, they are still a valid option. In fact, they can work really well with proper timing.

For example, I initially recommended a double inverse Dow ETF – the UltraShort Dow30 ProShares ETF (DXD) – to my readers back in August 2008. And on September 30, 2008 … I recommended doubling their stake in the DXD for additional downside protection.

What happened next? The Dow plunged about 2,400 points!

When I recommended closing out the hedges at the end of 2008, I tracked gains of 65.4 percent and 43.7 percent, respectively.

That’s powerful protection, indeed!

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