Chances are you likely had a successful year in the stock market.
Despite all the gloom and doom ranging from "Fiscal Cliff" fears to the threat of a global recession, your portfolio has probably weathered the storm, showing solid profits for 2012. On average, the S&P 500 gained about 15% last year, as you can see in the chart below...
However, the economy is not out of the danger zone yet. There is still much uncertainty about the rest of the world's economic troubles..
This fact forces the question: Should you take profits now or keep holding with speculation the upward momentum will continue?
This is quite a dilemma for investors sitting on a profitable portfolio. You don't want to see your profits wither away, but you also don't want give up on additional upside by booking profits prematurely.
Fortunately, there is a solution to this quandary. It's called hedging.
Hedging is the opening of positions in the opposite direction of the portfolio to protect your investments from downside risk, while keeping the potential for additional upside.
Hedging was once the province of only institutions and very sophisticated investors who would buy options and futures to hedge against their current holdings. But trading options and futures requires precise timing, special future and options accounts, and involves its own high-risk factors.
This is where exchange-traded funds (ETFs) come in. ETFs provide average investors like you and me with the right tools to protect our portfolio from heavy downside risk. It is no longer a must to open a risky futures or options account to hedge your portfolio. ETFs can easily be traded within your regular stock account without the hassle of using different brokers and accounts.
No free lunch
Unfortunately, there is no free lunch in the stock market. Hedging with ETFs is similar to an insurance policy. It is designed to protect your portfolio from a downside, but at a cost. A good way to look at this is to remember that when you buy an insurance policy, although it comes at a cost, the policy will protect you should the unexpected happen.
The cost of hedging with ETFs makes up some of the cost of the ETF, as it will not "expire" worthless like an option would and give up on maximum possible upside should things continue profitably in your portfolio.
How to do it
The wide variety of ETFs allow you to hedge different portions of your portfolio depending on which you believe is most at risk at the time.
Let's say your portfolio is heavily weighted with Nasdaq stocks and you believe the technology sector may suffer a sell off during the upcoming earnings season. You could then short the Power Shares QQQ ETF (Nasdaq: QQQ), which tracks the Nasdaq 100 Index.
Similarly, if you believe the total market may be heading sharply lower, then shorting the SPDR S&P 500 ETF (NYSE: SPY) could create a hedge for your entire sector-diversified portfolio.
Your time frame is critical
There are also inverse and leveraged ETFs, such as UltraShort S&P 500 ProShares (NYSE: SDS), that can provide short-term hedges for specific events. This inverse ETF corresponds to twice the opposite of the daily performance of the S&P 500.
An example would be if you believe a critical economic release would result in a sharp negative reaction in your portfolio. You could then purchase the inverse ETFs to hold just before and after the event. Leveraged ETFs are simply too volatile and uncertain to hold for the long term. However, they make a fine choice for protecting against specific daily events.
Risks To Consider: Hedging your portfolio with ETFs comes with a cost. This cost is a portion of the price paid for the ETFs and the opportunity cost of buying the ETFs, rather than investing the price paid directly into your directional portfolio. However, the benefits could save your portfolio should a sharp drop occur.
Action To Take --> My rule of thumb for hedging with ETFs is 10%. This means is I would short $10,000 worth of ETFs for every $100,000 valuation of my portfolio. This number can change up or down, depending on how strong my conviction is of any pending downside. However, 20% of portfolio value is generally the upper limit to hedge against all but the most extreme market drops.