The Best Bear Market Hedging Strategies
Editor’s Note: With the markets still showing plenty of volatility, we want to make sure you’re prepared for any dramatic swings. So we’re rehashing our top bear market hedging strategies to help you protect your assets.
– Ryan Fitzwater, Associate Publisher
Hedges are a good thing, but they are often misunderstood.
The truth is… hedges lose the majority of the time, but that’s because they’re typically used as a form of insurance – just like your homeowners policy.
When you pay for your insurance policy each year, you consider it money well spent.
You should think about hedges the same way. They’re the cost of doing business. If you have nothing to hedge against, don’t use a hedge.
In this series, I will share a bunch of different ways you can hedge, depending on your risk tolerance and how much capital you have available.
Let’s get into my favorite hedge: the tail risk hedge.
This strategy is based on protecting against an unpredictable black swan event (like the onset of the COVID-19 pandemic in March 2020).
There’s a lot of theory behind tail risk hedges, but I will give you the nuts and bolts.
How to Use a Tail Risk Hedge
First, you have to look at the CBOE Volatility Index, or the VIX. If it moves to 35 or 40, then boom – that’s your green light to implement this.
Second, you have to calculate how much you have invested in all of your stock positions.
For example, let’s say you have $100,000 in stocks. You multiply that by 0.5%, which gives you $500. You then invest $500 in S&P 500 put options (use the SPDR S&P 500 ETF Trust) that are 20% below the current price and expire in around two months.
In a black swan event, that investment of just $500 – or 0.5% of your total portfolio – should provide ample coverage to make up a big chunk of your losses. Look to buy options that have expiration dates two to three months in the future. We came up with 0.5% by back-testing a 30%-to-50% correction and figuring out which strike prices would likely work.
Black swan events are very rare, so this is not your everyday hedge, but when the VIX moves over 35 or 40, it is usually a signal of bad things ahead.
How to Use the VIX for Spreads
I like to use spreads on the VIX by trading the VXX, another volatility ETF. I will sell calls to reduce my cost. So for example, I will buy the $25 calls on the VXX that expire in mid-July and sell the $35 or $40 calls against the position. If I have a big position in a particular stock or sector and it’s not paying dividends, I will use a number of, let’s say 10%, as my max pain point for an event like earnings.
This means I will sell if I get a 10% move lower. I will then use that max pain number and sell my stock.
I will take up to 10% of the proceeds to buy call options that expire a week or two after the earnings are released. That lets me keep ALL my upside but protects my downside in case there is a massive move lower after the release. If the news is good, I can switch back into the stock with a minimal loss or even a gain.
Leveraged ETFs, LEAPS and Spreads
Now let’s get into three other methods I use in my portfolio to hedge in different situations.
Leveraged ETFs
These are great for trend moves. If the market is moving lower every day, I can hop on a leveraged ETF like the ProShares UltraShort QQQ (NYSE: QID), the ProShares UltraShort Dow30 (NYSE: DXD) or the ProShares UltraShort S&P500 (NYSE: SDS) to accentuate my returns. Just know that these reset daily and will not make you money unless you get a really big move right after you buy. A choppy market will not bring you gains through these assets.
LEAPS
Using LEAPS (long-term equity anticipation securities) is one of my favorite longer-term strategies in my options portfolio – especially on stocks that DO NOT PAY dividends. A LEAPS option is a proxy for owning shares and usually costs 10%-15% of what it would cost to buy the underlying stock. This is a great strategy to reduce your outlay while still giving yourself exposure to the potential gains of a stock. Plus, the one-to-two-year timeline gives you plenty of time to plan an exit strategy.
Spreads
I also look for ways to reduce my cost by using multiple options, or spreads, within the same trade. This is a good strategy for pure speculation plays, such as cheap options on potential flyers like Overstock.com (Nasdaq: OSTK) or Plug Power (Nasdaq: PLUG).
The strategy is also good for reducing the cost of plays on stocks like Meta Platforms (Nasdaq: META) or casino stocks, since those sectors are so volatile and the premiums are so high.
On down days, my spreads work like a charm because as one side loses, the other side gains.
In ALL cases, regardless of the strategy I’m using, POSITION SIZING is just as important as the strategy itself. Check out my article on the subject.
Why We Hedge…
Hedges are an insurance policy, much like leveraged inverse ETFs, and usually will not pay out.
On down days for the broader market, my hedges allow me to LOSE LESS (not lose zero). And on up days, I will make a lot more than I will lose on my hedges.
In this market, you should always have some hedges in place. BUT hedges work only if you have something to hedge against. That is the balance.
In an ideal situation…
- When the market goes up, your gains should outweigh the losses you incur from your hedges (“insurance payments”) by a country mile.
- When the market goes down, your hedges will protect you from major losses, similar to an insurance policy.
Action Plan: We use both short- and long-term hedging strategies like these all the time in The War Room. The beauty of joining is you get to see us implement these trades in real time. In fact, my partner Bryan has been killing it with his short-term hedges, to the tune of a 90% win rate and 45% total returns in 2022.
