Trader looks at market graph 311 (R).
(photo credit:REUTERS/Tony Gentile)
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
Doesn’t seem like a recipe for the recent market rally to
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.
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
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
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
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
Speak with your financial adviser to see if these approaches fit
your risk profile and whether they have a place in your
firstname.lastname@example.org Aaron Katsman is a licensed
financial adviser in Israel and the United States who helps people with US
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