The US is heading toward a fiscal cliff.

Both the US Federal Reserve and the Bank of Japan just announced the effective printing of more money, gold is surging, Europe is imploding, the threat of an Iran/Israel war is still on the front burner, and we have the uncertainty of US presidential elections.

Doesn’t seem like a recipe for the recent market rally to continue.

Did I get your spirits up? Well REM may “feel fine” with the end of the world, but investors are skittish. I don’t mean to be the bearer of bad news; in fact, I am personally much more upbeat on global economic prospects than many people.

It’s just that over the past few months I have had many conversations with both actual and prospective clients who believe the world is headed for a disastrous couple of years.

As such, these clients want to know how they can potentially profit from Armageddon. While there are many different solutions to this question, I would like to focus on three approaches to protect your capital and even profit from a stock-market drop.

Options


The classic way to cushion your portfolio against a market drop is by buying “insurance.” Buying put options as an insurance policy on your portfolio is like having homeowners insurance to protect your house against a fire. A put is an option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. A put option is basically a bet that the market will drop. If it does, the investor makes money. If wrong, the initial investment in the put is lost.

Volatility

Many professional investors like to look at market volatility as an indicator of future stockmarket performance. The VIX Chicago Board Options Exchange (CBOE) Volatility Index shows the market’s expectation of 30-day volatility.

The VIX is a widely used measure of market risk and is often referred to as the “investor fear gauge.”

According to Edward Szado, a research analyst for the Center for International Securities and Derivatives Markets at the University of Massachusetts: “Investable VIX products could have been used to provide some much-needed diversification during the crisis of 2008... The performance of markets in recent years suggests that VIX may spike upwards as the S&P 500 experiences large drops, leading one to believe that a long VIX position could provide significant diversification benefits to an equity portfolio.”

There are a few new products structured to capitalize on movements in the VIX. Keep in mind that investing in volatility is very new for most investors and comes with risks.

Investors need to take the time to understand how these products work.

Cash is king


 I am not the biggest believer in market timing, and trying to accurately predict a big fall is not the easiest thing in the world. As such, while the two methods mentioned above to try and make money on a market drop may work for some, I tell most of my clients that if they are worried about a market fall, they should sell some stock and move into cash.

The worst-case scenario would be that they are wrong and the market continues moving higher, in which case they wouldn’t participate in the upside. On the other hand, if the market does go down, they retain the value of their portfolio, and when the point comes that stocks are at an attractive valuation, they can move back into the market.

Speak with your financial adviser to see if these approaches fit your risk profile and whether they have a place in your portfolio.

aaron@lighthousecapital.co.il Aaron Katsman is a licensed financial adviser in Israel and the United States who helps people with US investment accounts.

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