How to Hedge against a Market Crash

While the topic of hedging has gained in popularity recently, I claim most investors have not made changes in the fundamental basics of portfolio design. Many newcomers, and even some longtime investors, have misconceptions about how to hedge and prepare a crash-safe portfolio.

Here are my six most commonly-seen fallacies about hedging against a market correction, market crash, or bear market.

 

Myth 1: You Only Need to Hedge before a Crash 

Wrong for several reasons. First, you cannot time a market crash. So if you fool yourself into the mindset of, “I’ll just hedge before the crash happens,” you’re essentially saying you’re the Nostradamus of trading.

Second, even if a market crash does not occur, you still are exposed to the two or three market corrections (i.e., mini-crashes) that occur every year. By not hedging against these, you will see an immediate 5% drop in your portfolio, on average, every time a market correction occurs. By hedging, you can gain that 5% back as a short-term profit, sell, and rehedge after the market bounces back.

Honestly, you should be hedged 100%. This does good for both your portfolio and your state of mind. If you’re hedged all the time, you won’t have to worry about market crashes, corrections, or bear markets.

Myth 2: Buying Funds before the Crash Is Best Way to Hedge

Studies have shown that investors are notoriously bad at timing fund purchases. Whether it be a mutual fund, index fund, or ETF, you’re most likely to buy it the wrong time. Statistically, when you buy a fund, you tend to buy it before it falls and sell it before it rises – the facts don’t lie.

Why do investors fail so hard with funds? This has to do with the first myth. People tend to buy funds, such as inverse ETFs, when they believe that the market has reached a top.

The problem with this is that most investors are horrible at picking a “top.” They either buy an inverse ETF while the market’s on the rise – losing money – or they buy a fund while everyone else is panic-selling – buying the fund at an overvalued price.

Myth 3: To Stop Playing Is the Appropriate Response to a Crash

By “stop playing” I mean stop buying. Hopefully you already know that selling during a market crash is a horrible idea. But you might not know that quitting the market and letting your portfolio sit is just as bad an idea.

If you were heavily invested prior to the crash of 1929 and stopped buying stock during and after the crash, you wouldn’t have been made whole until 1954. That is, it would take you 25 years to recover from your lack of hedging and lack of play during the bear market. Similarly, you would still be in the red today if are still holding onto a portfolio from 2000 (i.e., you didn’t buy during the bear market).

The solution is to buy during the bear market. In my course, I recommend several equities and methods of buying during a bear market. But the short of it is that if played the right way, you can come out better than before if you play the bear market.

Myth 4: No One Can See the Crash Coming

…Except for all those that did in 2008 and walked away with loaded pockets. Both fundamental and technical analysis can help us predict a market crash. It’s hard to predict the exact timing, but the fact that a crash is coming is often quite predictable.

To predict a market crash the fundamental way, your best bet is to carefully watch leading indicators strongly tied to economic health. Leading indicators are remarkable in that they give us a preview of what’s to come in the subsequent indicators. By following the leading indicators, you gain advanced knowledge about the market’s state.

Three of the most important leading indicators are the Empire State Index, Housing Starts, and Consumer Price Index (CPI). Each explains a different aspect about the future of the economy. For example, the Consumer Price Index is useful in that sudden changes in its price mark significant changes in inflation (rise in CPI) or deflation (drop in CPI).

A few other leading indicators useful in predicting a market crash follow. Try using these in a backtest of previous market crashes. Look at how these values changed before the crashes in 2012 or 1987, for example:

1. Jobless claims
2. Markit PMI
3. Chicago Fed national activity index
4. Home prices
5. Durable goods orders
6. Personal income

Myth 5: Playing in a Bear Market Is Risky

If played right, playing is a bear market is safer than playing in a bull market. The reason is that it’s usually quite clear when a bear market is coming to an end, whereas we don’t really know when a bull market is coming to an end. Thus, playing short positions in a bear market is often safer in that we know when to cover our shorts; we don’t always know when to sell in a bull market.

But an even safer way to play a bear market is to use put options instead of shorting stock. It’s true that shorting stock exposes you to limited risk. But buying put options limits your risk to the money spent on the put option – it’s much like buying stock.

By buying put options during a clear recession or market crash, you can get 100 times the profit for the same price of shorting stock. My personal bear market profit scheme is to buy puts on stocks and ETFs that are sure to drop. I have a good friend who made his fortune buying puts on the QQQ during the market crash of 2008.

Myth 6: You Should Switch to a Short Portfolio during a Bear Market

Just like you should hedge during a bull market, you should also hedge during a bear market. While I agree that bear markets are safer and more predictable than bull markets, you should still be hedge 100% of the time, no matter whether you’re bullish or bearish on the market. Hedging is just a smart decision, regardless of the current market conditions.

Hedging during a recession is simply holding long positions on certain industries and sectors that might spike even during a bear market. For example, biotech and tech companies still have opportunities to make breakthroughs during a bear market. A biotech company might find the cure to cancer; a tech company might start seeing huge sales in robot laborers.

Then there are commodities, foreign markets with low correlations to the US market, and other equities that can easily prosper during a bear market. Locate them and hold long positions, even when you’re mainly short. You can discuss some of your ideas in the discussion forum once you sign up for my market crash course.

In my market crash course, I teach four main ideas:

1. How to predict a market crash
2. How to prepare (hedge) against a market crash
3. How to play a bear market to set yourself up for the next bull market
4. How to play the bear market aggressively to profit while others are losing money

Get it here!