As investors become more and more nervous about the prospects for the equity markets, many have considered hedging their portfolios against a market downturn. Historically hedging techniques were difficult to implement for the individual investor as they required an investor to short stocks and/or may have required an investor to have a margin account to implement the strategy. However with the wealth of new Exchanged Traded Funds (ETF) becoming available to the public, there are some simple ways to hedge your portfolio against market downturns.

We will discuss a hypothetical portfolio in this article. Let us assume an investor has a portfolio valued at $120,000 and consisting of cash of $30,000 and stocks with a market value of $90,000. Let us further assume the stocks have appreciated greatly since being purchased for $45,000. Additionally, the stocks are paying a dividend yield of 3% on today's value so they are providing an annual income of $2,700. However, our investor is becoming concerned that the market is overvalued and may drop soon.

Why would someone want to hedge their portfolio? In the above scenario, selling appreciated securities would result in a tax liability on the gain of $45,000, the loss of the annual income from the dividends as well as any future appreciation if the market downturn is temporary.

In order to protect against the possibility of a market downturn our investor decides to hedge his portfolio. Assuming the portfolio is a bunch of blue chip stocks, the easiest way to hedge the portfolio is to purchase an Exchange Traded Fund or ETF which goes up when the market goes down. In years past the only way to protect against a downturn would have been to short stocks or purchase put option on an index or individual stocks. With the increase of ETFs you can now purchase inverse ETFs which appreciate in a declining market. Additionally, certain ETFs are designed to appreciate in multiples of the rate of the market's decline. So a 2X inverse ETF increased in value 20% if the market declines 10%, a 3X inverse ETF will increase 30% in a market that declines 10%. Please be aware that the returns are not always in the exact proportion to market changes as ETFs use a variety of techniques to create their results and also have a decay factor over time. If you are using them for a protracted period of time, the results may not correlate exactly. For shorter periods of time the results will be close. Additionally, please note that an ETF will not correlate exactly to performance of your individual stock portfolio, but this is designed to be a simple strategy requiring you to make only one or two additional trades.

Step One

Select the appropriate hedge security for your portfolio. If you have a portfolio of Blue Chip stocks that will most likely move in concert with the S & P 500, you should select and ETF which has inverse performance to the S & P 500. If you have a portfolio with banking stocks you would look for an ETF which is inverse to banking stocks, same with a portfolio of energy stocks etc. If you have a diversified portfolio, you may wish to select a few inverse ETFs to create a hedge for portfolio. Tools available to help you find inverse ETFs include.

Step Two

Calculate how much of a hedge you wish to purchase. You can protect your portfolio for drops in the market by the types and amounts of ETFs you purchase. There are ETFs that move in an inverse direction to the movement of certain indices and securities in multiples of one to three times the movement of what they track. So you can hedge your portfolio from between zero and one hundred percent depending on what you purchase.

In the above example, if the investor wishes to protect its entire portfolio of $90,000 in stock, it would do so by purchasing $30,000 of a 3X inverse S & P ETF. In the event the stock market falls by 15% in the next six months and assuming his portfolio follows, the value of the $30,000 would rise to offset the losses.

Step Three

Monitor the portfolio. You want to monitor the portfolio for two things. Firstly, you want to make sure you want to keep the hedge in place. If you think the market will reverse directions and want to participate in the upside, you can sell the hedge security, hopefully at a profit and enjoy the upside. Some people will use the profits from the hedge to buy more of what they believe will appreciate.

Let's look at the math, ignoring taxes and commissions.

No Hedge Scenario

Today Six Months Later
Cash $30,000 $30,000
Original Stocks $90,000 $76,500
Earnings * $ 1,500
Total $120,000 $108,000

* Assuming Cash earns 1% ($30,000 x 1% / 2 = $150)
Half a years Dividends ($90,000 *3% / 2 = $1,350)

The portfolio is now worth 10% less than it was before the market drop

Hedge Scenario

Today Six Months Later
Cash $ 0 $0
Original Stocks $90,000 $76,500
3X Inverse ETF $30,00 $43,500
Earnings ** $ 1,500
Total $120,000 $121,500

** Since the cash was used to buy the ETF, there are no cash earnings.
Half a years Dividends ($90,000 *3% / 2 = $1,350). Note we assumed the stocks which paid a dividend yield of 3% on the original portfolio, did not reduce its dividends.

The portfolio is now worth 1.25% more than it was before the market drop.

So, the hedge has protected the value of the portfolio from a severe market downturn and the investor still has its principal balance.

Now the obvious question is what would have happened if the investor's instinct was wrong and the market took off by 15%. In this instance, the investor would have ended up with a portfolio worth $121,500 if the hedge strategy was in place versus a portfolio worth approximately $135,000 (12.5% more).

The second element you want to monitor is how the hedge security or ETF is performing. So, if the market has fallen by 5%, your 3X inverse security should have risen by 15%. Continually monitor your hedge securities to see how they are tracking. As we discussed, no ETF is exact and they experience decay as time marches on, so you may need to switch ETFs or purchase more to keep the results where you would like them to be.

So obviously a hedge strategy caps both your upside and downside and should be employed sparingly.