Equities in the United States have been in a bull market since 2009, with stocks reaching new peaks following the 2008 financial crisis. As of the end of May 2016, the Dow Jones Industrial Average (DJIA) had a seven-year return of 109.19%, and the S&P 500 Index had a seven-year return of 136.40%. With valuations inflating, many investors are concerned about the potential risks of a market crash, which is typically characterized by losses of over 20% over a prolonged 12-month period. While these crashes are often few and far between, wise investors are prepared with strategies to mitigate potential losses. In the case of a market downturn, the following five investing strategies can help you to protect your investments.
Fixed Income and Treasuries
Seeking fixed-income safe havens, such as Treasurys specifically, is the most basic way to protect your investments from market downturns. If valuations are rising and economic indicators are lagging, then the market is reporting a disconnect and valuations will surely fall as they are efficiently priced over time. For investors, raising cash from mutual funds and other liquid investments and transferring them to Treasurys when anticipating or experiencing the effects of a market downturn can greatly protect against losses. Treasurys can always be relied upon for investors as a safe haven since Treasurys essentially have no risk. More specifically, investing your cash in Treasury Inflation-Protected Securities (TIPS) ensures a rate of return while still beating inflation.
Another safe haven for investors is hard assets such as real estate. Securing and investing in real estate property at a stable value can give you peace of mind in the case of a market downturn. With real estate, your investment is backed by a hard asset with tangible value. At the same time, homeowners should also be cautious of added financial burdens related to real estate. Added burdens such as additional home equity lines of credit can harm a homeowner’s credit profile and increase interest payments, adding risk during a potential market downturn.
Hedging with Put Options
If you are tied to some of your higher-risk investments, the best way to hedge against potential market losses is to buy put options. Put options provide you with an option to sell when security levels reach a specified low point. The available range of offerings for put options is wide, providing a number of investments for hedging. If covering direct stock investments, investors can buy corresponding put options. If identical options are not available, then investors can turn to more sophisticated synthetic put option strategies that replicate a portfolio through put options providing for comprehensive selling in a market downturn. For more general protection, investors can also utilize index put options that can be exercised when a market index reaches a specified low. Put options come with a cost, like all types of insurance, and the risk of entering into a put option that expires unexercised is the loss you incur from the put option's cost with no exercised benefit.
A reverse strategy for buying put options to protect against a market crash includes selling call options. When selling call options, a seller expects the price of a security to fall and seeks to identify a buyer who is willing to buy the call option for the right to buy the security at a specified price. The seller of the call option benefits from the buyer’s purchase of the security at a higher price than the seller anticipates it to be valued in the trading market. Similar to put options, call options are traded for specified securities and indexes. More complex call option selling strategies can also be developed to synthetically replicate and protect specified investment positions.
A final option for investors who foresee a market crash on the horizon is to invest in market-hedged products providing for protection from specific downside risks. A number of these investments exist, with some of the most well-known of these investments being inverse exchange-traded funds (ETFs) and leveraged inverse ETFs. Examples include the AdvisorShares Ranger Equity Bear ETF (NYSEARCA: HDGE) and the ProShares UltraShort NASDAQ Biotechnology ETF (NASDAQ: BIS). These funds take an active inverse market position that seeks to benefit from a market downturn or crash. Leveraged inverse ETFs take the short-side protection one step further by employing leverage to enhance the gains from short-selling positions. These inverse funds are designed specifically for situations where severe losses can be incurred from a market downturn.
Overall, these five options provide investors with varying levels of liquidity for managing a potential market crash. Hard assets can provide security through tangible value. Shifting assets to safe havens, such as Treasurys, provides a liquid and simplistic approach that can be enacted relatively quickly if investors foresee signs of a market downturn or crash. Put options, call options and inverse strategies are slightly more sophisticated to employ. Put and call options can primarily be traded actively, allowing for investment coverage relatively quickly. Similarly, inverse strategies are typically traded daily with high levels of liquidity, allowing for comprehensive coverage through block investment trades. Both indexed options and inverse strategy funds are good to include as an added layer of risk protection through all market cycles in any portfolio; however, they can be even more optimally utilized in the case of a market crash. With options requiring synthetic strategies to cover portfolio risks, trading can be more complicated with less-allowable liquidity for immediate market downturns.