How to protect yourself – with caution – against a market correction


How can you hedge your investments against the risk of falling stock markets – and maybe even make a profit – if the market collapses?

By “reservoir” I mean an appropriate correction of 10-30%. It is worth thinking about it, because I think this scenario is becoming more and more possible, even probable, by the day.

Market experts have always made it a point to warn individual investors of the risks of trying to time the market, but people nonetheless wonder what they can do when they consider what so many observers tell them. market: that US investors in particular ignore increasingly obvious warning signs about the withdrawal of quantitative easing, inflation and the problems in China.

So, if you are the type of adventurous and eager to try your hand at market timing, what should you invest in?

Spread betting offers all kinds of leverage or tailored ways to play the ups and downs of the markets, but they present challenges that make it a no-no for me: you have to open and fund a separate account, you can’t use a tax envelope like an Isa and if you don’t plan properly you could end up losing more than what you initially invested.

An alternative are short and leveraged trackers (S&L). These follow the major indices and accelerate returns upward (with leverage) by one to three times the daily return and downward (short) the same. Many large issuers of exchange-traded funds, such as WisdomTree, Deutsche Bank, and Legal & General Investment Management, are active in the S&L space.

Traditionally, anyone who talks about these products, which track daily returns, issues a health warning – because if you dwell on them for more than a few days, you could seriously destroy your wealth.

Take the example of an index that starts at 100 on the first day. At the end of the day, it drops 5%, then increases 5% on the second day, drops 5% on the third day, and rises again on the fourth day. In fact, you don’t come back to 100 by the end of day 4 – the final figure is 99.5%. But the leveraged 3x tracker and the short 3x tracker end the fourth day at 95.55%.

Like I said, this build-up of daily volatility is killer. Once we get to weeks and months, the effect can be catastrophic. No wonder these products have been labeled as suitable only for day traders.

But it doesn’t have to work that way. S&L products can save your life if you want to cover a portfolio for weeks or even months. Markets don’t always move at random. They have a trend, although there are variations within this trend.

Why? Because investors are like a mad crowd, likely to go from bullish to bearish based on market narratives that tend to last for long periods of time (by that I mean weeks and even months). Let me explain with some tough numbers.

Among the latest massive sales – September 2020, February 2020, fall 2018 and July 2015 – some were just duds. In September 2020, for example, the S&P 500 was down just under 10%. But others were serious 20 to 30 percent rashes.

In either case, if you had bought a short leveraged tracker on, say, the S&P 500 at the bullish high, then sold at the bearish low, you would have made spectacular profits (and spectacular losses with the effect version. leverage).

This level of foresight is quite implausible, however. So I went back and looked at a longer period, in most cases a good three weeks before the bullish high, then a few weeks after the bearish low. Outside of September 2020, you would still have made a decent profit or at worst lost a percentage point or two (in 2015-16).

Take February 2020. The bullish peak for the S&P 500 was around February 21 and the bearish low was on March 23. The S&P 500 fell 33% in those four weeks. In contrast, LGIM’s 2x tracker rose 86 percent and WisdomTree’s 3x tracker climbed 132 percent.

But what if you bought the same short trackers on February 1 and then stayed tight until April 2020, when the markets rebounded aggressively?

Traditional warnings would have said that disaster awaits. In fact, the 2x and 3x examples recorded a gain of between 30-35%. Obviously, if you had waited to release until mid-April when the markets were really storming, you would have thrown good after bad, but my general point is the same. These daily trackers can run for weeks and even a few months.

For more evidence, consider the reverse scenario – bull markets, where the trend has been steadily increasing over the past year. In the 12 months to October 25, 2021, the S&P 500 is up about 31.7%. But a 2x leveraged (bull) tracker from LGIM is up 74.4% and a 3x from WisdomTree is up 123%. Even moving departure days by a week or two, for example, doesn’t make much of a difference in terms of returns.

The key, then, is to focus on observing the mood of the market and trying to make sure that you are not too late for a drastic change in sentiment. It is also beneficial to monitor your tracking index. Consider the gold. We’ve all been trained to think of gold as a safe haven asset that should do well when investors panic. Thus, one would have thought that a leveraged short tracker on gold would do well in the turbulence of the market. Unfortunately, the numbers suggest otherwise. Only the upheaval in the markets in September 2018 brought great relief.

A riskier index could sell more aggressively in the event of a market panic. The FTSE 250 has companies that are much smaller, in terms of market capitalization, than the FTSE 100 and sold 40% in February of last year. The 1x short on this WisdomTree index actually rose in value almost 60% from top to bottom. Even adding a few weeks on each side, you would still have made 40 percent.

So for the adventurous investor who understands the risks and is willing to think short term – but doesn’t turn into a day trader – short and leveraged trackers can and have made sense. Just treat with caution.

David Stevenson is an active private investor and has an interest in the securities mentioned. E-mail: [email protected]. Twitter: @advinvestor

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