An ETF Hedge to Smooth the Waves

06/25/2012 9:00 am EST

Focus: ETFs

Bryan Perry

Editor, Cash Machine, Premium Income, Quick Income Trader, Instant Income Trader

With all the turmoil in the markets these days, it makes sense to put in a simple hedge to add some value to your portfolio when the bad news outweighs the good, writes Bryan Perry of Cash Machine.

Following a sharp oversold rally that helped the major averages recover some of the May declines, volatility is returning to the market in front of several key developments both here and abroad.

I think buying some portfolio insurance now makes sense from the standpoint of not expecting the best of outcomes for the European debt crisis, the Greek election possibly leading to that nation's exit from the European Union, the wrangling in Congress over the year-end fiscal cliff that would require a trifecta of legislative miracles to curtail it, and a second-quarter earnings season that could see several companies guiding lower for the second half of 2012.

I'm shorting the Russell 2000 Index by recommending going long the Direxion Daily Small Cap Bear 3X Shares (TZA) at the market price of $21.38. The shares will go up 3% for every 1% the iShares Russell 2000 Index trades down.

A break back below $75 will invite further selling, and being that small-cap stocks trade with the highest beta, there's a good chance of not just technical selling, but of P/E multiple contraction, too.

That's why I recommend that you take a position as we head into what may be a very choppy time for the markets so we can hedge our downside risk. For every $100,000 invested in the market, a purchase of 1,000 shares would be a good way to leg into this hedging strategy at this time. I would then buy another 500 shares if the IWM breaks down below $75.

If the IWM has a two-day close below $75, then a move down to $70 is very possible, representing a 6.5% decline in the IWM shares. If this move occurs, then shares of TZA will advance by roughly 20%, where a 1,000-share position would gain about $4,400, insulating downside risk to 4.4%. A 1,500-share position for a $100,000 account will protect against a 6.5% decline under the same conditions—or about the same percentage as the target decline for the IWM.

If bought with cash, a 1,500-share TZA position will cost $33,000 and, if bought on margin, will cost $16,500. I believe this is the best bang for the buck in the way of using a single ETF that's enormously liquid (average daily volume is 20+ million) and also has options that can be used by more sophisticated investors. TZA is a buy under $22.

Related Reading:

Don't Sell...Just Rotate

5 ETFs to Profit from the Volatility

A Fund to Ride Tailwinds in Any Economy

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