How You Can Hedge This Volatile Market

FROM WORST TO FIRST TO WORST

NEWS: The financial stocks led the two-week and today it was those same financials that sent the market lower by over 2%. The Dow finished the day down 283 points or 2.4%. The S&P dropped 29 points or 2.3%. The NASDAQ held up a little better, tumbling 2% or 45 points. The hardest hit was the S&P 400 Mid-Cap Index, which fell 3%. Oil finished up nearly 1% and Gold ended down 50 cents.

THE BOTTOMLINE: The financial indices fell 6% today as investors began to think once again about the credit crunch and the possible global economic slowdown. The hardest hit were the big winners of the short-lived rally: financials, homebuilders, airlines, autos, etc. In a study we did on the best performing S&P500 stocks during the oil pullback, we found the above-mentioned sectors were the winners. BUT, of the top 20 stocks during the oil pullback, only one lost less than 6% today (Barr Labs - takeover stock). Think about that!

The 20 best performers during the last two weeks got crushed today; 15 of them fell at least 10%. The point I am trying to make by repeating myself is that the volatility and rotation of money from day-to-day is out of hand. Believing you can catch each wave is of money flow is impossible if you are a long-term investor. The best strategy is to hold onto your core portfolio and play defense until the market is at a better place.

Let me put this into an analogy. Imagine you were surfing off the coast of Australia and there was a storm at sea and the waves were huge. As an average surfer this may not be what you are looking for because it can be very dangerous, therefore you sit with your board on the beach. If you are a risk-taker you attempt to catch each big wave, but realize you will wipeout from time to time. But, what if the waves become to pickup and you try and keep up with the force of nature?

This is when the surfer who is trying to catch every wave will eventually begin to wipeout more and more and over time will end up back on shore, battered and bruised. The key to this market is to determine if you are the surfer watching the waves from the shore or the surfer that attempts to ride every wave. You need to make that decision, but realize that if you get too battered and bruised riding the abnormally large waves, you may not be healthy enough to get back in the ocean when the waves return to normal!

CHARTOLOGY

NEWS: The major indices ran into a roadblock of resistance yesterday and today felt the brunt of the failure to break through. The S&P 500 and Dow both put together solid bounces the last two weeks, but when it was time to break through the first level of price resistance, they both failed miserably. The chart below shows the failure of the Dow at a price resistance level that was drawn from the old lows.

When support is broken, it does a role reversal and turns into resistance. The line on the chart is a former support line and now will stand in the way of the index putting together a sustainable rally. Both the Dow and S&P 500 are in danger of retesting their July lows and if this happens, look for the financials to lead the market lower.

HEDGING WITH ETFS

NEWS: Now that the major indices have run into a stiff wind, it would not be a bad time to think about hedging your long portfolio against any downturns in the coming weeks. One strategy involves buying Short ETFs that will go up when the underlying index falls. It could be looked at as buying insurance against your portfolio.

THE BOTTOMLINE: The number of Short and UltraShort (leveraged 2-to-1) ETFs in the market has increased over the last year and a large number of them trade large volumes. Most investors would consider a Short ETF that tracks one of the major indices such as the ProShares Short Dow 30 [[dog]] or ProShares Short S&P 500 [[sh]]. If you want to be more aggressive, there are Short ETFs that track more narrow indices and individual sectors.

And if you want to be even more aggressive, there are the leveraged UltraShort ETFs. This can become handy for investors that do not have a large amount of capital and would like to gain a certain amount of exposure to the market. For example, buying 10% of the ProShares UltraShort S&P 500 (SDS) will in actuality give your portfolio 20% exposure to the short side of the market. Typically the leveraged ETFs should only be used by experienced investors due to their volatility.

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