Hedging with an ETF

By Travis Johnson, Stock Gumshoe, November 19, 2008

I’ve been largely trying to hedge against catastrophic declines by using occasional options trades, usually buying put options (as I mentioned I’ve done with Vostok Nafta — to protect against the general downside in Russia I own puts against the RSX index, and have rolled over those puts to another expiration date, those puts, unfortunately, are the strongest performers in my personal portfolio right now).

And while I’ve done some other options dabbling for protection, I decided yesterday to cycle out of most of those and just put on a position in the ProShares UltraShort S&P 500 ETF (SDS) — an inverse ETF which aims to return double the negative performance of the S&P 500 Index.  So if the S&P 500 goes up by 5%, this inverse ETF goes down 10%, and vice versa.

I chose the UltraShort instead of just the Short (which is non-leveraged, just returns a mirror of the S&P 500) because I wanted to commit less capital but cover more of my portfolio to the downside.  I could have done something similar with buying puts, but that takes more management and provides a rockier ride.

I have committed about 5% of my portfolio to this hedge position, and won’t likely be trading in or out much — this is protection against further cataclysm, not a bet that the market will go down.  Effectively, that 5% means that I am getting downside protection equivalent to about 10% of the portfolio — I am still overwhelmingly long, even if you count any put option positions in my portfolio, this is essentially a way for me to simplify my hedging a little bit.  It’s quite possible, of course, that my portfolio could significanlty underperform the S&P 500, which could mean that this would be a losing position and an ineffective hedge, but my holdings, including mutual fund positions that I don’t write about very often, have over time correlated fairly closely with the index, so this is as reasonable a hedge as I can easily add.

Hopefully, I’ll lose money on this ETF.

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