The Dow (NYSE:DIA) broke the all-important psychological 11,000 level this week and the S&P (NYSE:IVV) is flirting with 1,200. The economy seems to moving in a positive direction as higher consumer confidence and higher corporate earnings are becoming the norm. However, the picture isn't necessarily all that rosy. Sovereign debt worries from Greece, Spain and Dubai still plague the headlines. Massive looming federal and state budget deficits will result in higher taxes. Even with the recent job creation, unemployment is still very high and the number of underemployed is growing. The real question now for investors after the recent run-up in asset prices is what the future will bring.

IN PICTURES: How To Make Your First $1 Million

We All Could Use a Financial Hedge
Over the long term, stocks have typically been the best place to put your money. But after the recent financial beating, many investors are finding little to no comfort in historical trends. Older investors planning on retiring soon don't have much time to recover if asset prices plunge another 55% as they during the height of the crisis. Younger investors are plain spooked by the recent events and many have altered their investing styles. There are real worries out there. However, just as a homeowner who lives in a flood plain takes out insurance against such an event, many investors would sleep better at night if they build hedges into their portfolios.

If there is one lesson to be had from the financial debacle, it's that in the time of real crisis almost all asset classes seemed to fail. Simple diversification in a complex global economy may not be enough to save investors from heavy losses. However, with the recent exchanged-traded products boom, retail investors have been giving some sophisticated tools to help protect their portfolios from large market downturns.

Strategies for Insurance
Options strategies have often been the realm of day traders, high net-worth individuals and institutions, and are often ignored by the retail investor space. Today, however, using ETFs, a simple covered call or buy-write approach, is attainable for any sized portfolio. A buy-write at its simplest form is where an investor buys a basket of stocks tied to an index and writes call options that cover the stock position. The income generated from the option helps cushion sideways and downward movements in the index or stock price.

The PowerShares S&P 500 Buy-Write (NYSE:PBP) and the PowerShares NASDAQ-100 Buy-Write (Nasdaq:PQBW) offer investors a way to hedge their bets against two of the larger broad-based stock indexes. Both funds charge 0.75% in expenses and will underperform the indexes in bull market mode, but will help limit losses if there is another major downturn. Investors wanting to hedge a global portfolio can turn to the Eaton Vance Global Buy-Write Opportunities Fund (NYSE:ETW) which holds about half of its stock allocation outside the United States.

Inverse ETFs allow investors to bet against (short) various market indexes without technically having to short a financial asset. They come in variety of flavors, tracking various indexes and degrees of leverage. Day traders aside, for most investors the broad based non-leverage variety, are the best for hedging a portfolio.

The ProShares Short S&P 500 (NYSE:SH) and the ProShares Short Dow 30 (NYSE:DOG) are ways to play the big indexes' downfall. These funds aren't perfect; investors should understand that these funds reset daily, which over long periods can result in tracking errors.

The Chicago Board Options Exchange's Market Volatility Index (VIX) is essentially, the equity market's key gauge for fear and it has been dropping as the economy has been in rebound mode. A direct investment in the VIX is not possible; investors can participate through futures contracts on the index.

Playing the markets "fear" is similar to shorting equities. Investments in the iPath S&P 500 VIX Short-Term Futures ETN (NYSE:VXX) which follows the two closest monthly contracts and the iPath S&P 500 VIX Mid-Term Futures ETN (NYSE:VXZ), which extends its contracts longer, are direct plays on this sentiment.

The Bottom Line
While the market has been on a tear the past few months, it's easy to throw caution to the wind and forget about portfolio insurance. The exchange-traded products boom has made it possible for regular retail investors to add sophisticated portfolio hedges quite easily. The global situation is getting better, but there is still much uncertainty in the economy. Prudent investors would be wise to add some indemnity to their portfolios.

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

Related Articles
  1. Chart Advisor

    Gold Struggles to Climb Higher and May Fall Soon

    Traders will be watching the price of gold over the coming weeks. We'll take a look at how a couple major moving averages are suggesting that the next move could be lower.
  2. Mutual Funds & ETFs

    ETF Analysis: United States Brent Oil Fund

    Learn more about the United States Brent Oil exchange-traded fund, the characteristics of the fund and the suitability and recommendations of it.
  3. Mutual Funds & ETFs

    ETF Analysis: ProShares Ultra Bloomberg Crude Oil

    Find out more about the ProShares Ultra Bloomberg Crude Oil ETF, the characteristics of UCO and the suitability and recommendations of UCO for investors.
  4. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI Hong Kong

    Learn about the iShares MSCI Hong Kong fund, which invests in various equities of companies listed on the Hong Kong Stock Exchange.
  5. Mutual Funds & ETFs

    ETF Analysis: Vanguard Small-Cap Growth

    Take a close look at the Vanguard Small-Cap Growth ETF, which focuses on domestic small-cap equities with a fundamental growth strategy.
  6. Mutual Funds & ETFs

    ETF Analysis: First Trust Dorsey Wright Focus 5

    Take a closer look at the First Trust Dorsey Wright Focus 5 ETF, a unique and innovative fund of funds based on momentum and relative strength.
  7. Mutual Funds & ETFs

    ETF Analysis: iShares National AMT-Free Muni Bond

    Take an in-depth look at the iShares National AMT-Free Municipal Bond ETF, a highly diverse and very popular muni bond fund.
  8. Mutual Funds & ETFs

    Top 3 Switzerland ETFs

    Explore detailed analysis and information of the top three Swiss exchange-traded funds that offer exposure to the Swiss equities market.
  9. Stock Analysis

    Net Neutrality: Pros and Cons

    The fight over net neutrality has become an amazing spectacle. But at its core, it's yet another skirmish in cable television's war to remain relevant.
  10. Mutual Funds & ETFs

    7 Best ETF Trading Strategies for Beginners

    Exchange-traded funds are ideal instruments for beginning traders and investors. Learn the seven best strategies for trading ETFs.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  3. Exchange-Traded Mutual Funds (ETMF)

    Investopedia explains the definition of exchange-traded mutual ...
  4. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  5. Sucker Yield

    When an investor has essentially risked all of his capital for ...
  6. Lion economies

    A nickname given to Africa's growing economies.
RELATED FAQS
  1. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  2. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  3. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  4. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  5. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  6. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!