Your Investments: Beginning of Armageddon?

Three ways to profit from a market drop.

By AARON KATSMAN
Europe is suffering through a sovereign-debt crisis. Analysts are saying there is a very real chance that a large European bank is going to go under, creating a financial crisis that will make the Lehman Brothers fiasco look like child’s play. The American economy is on the verge of heading back into recession, and virtually no one believes that President Barack Obama has a plan to put the country back on track.
Closer to home, Israel’s relationship with Turkey is on the rocks. The upcoming unilateral Palestinian declaration of statehood could plunge the Middle East into further chaos.
Cheerful enough! 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 in the last 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 both hedge and profit from a stock-market drop.
Inverse ETFs
Exchange Traded Funds (ETFs) are defined as securities that track an index, a commodity or a basket of assets like an index fund, but trade like a stock on an exchange. For example, if an investor wants exposure to the S&P 500 stock index, he can either buy all 500 stocks, which would be very costly and time consuming, or he can purchase an ETF. Most investors use ETFs because they want a low-cost, non-managed way to capitalize on a stock-market rally.
Recently, however, new “inverse” ETFs allow investors to profit from a market decline. If the market goes down, they should go up and vice versa. Inverse ETFs are now available for most major market indices and sectors. For example, if an investor thinks that Obama’s proposed regulation will drive down shares of banks, he could choose to profit from the decline by purchasing an inverse ETF linked to the banking index.
Volatility
Many professional investors like to look at market volatility as an indicator of future stockmarket performance. The VIX Chicago Board Options Exchange 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.
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.
While these methods may be an effective way to profit from market decline, they can be quite complicated to implement. 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.