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3 Strategies for Hedging Against a Market Crash

After 2013’s stellar market returns, it’s human nature to be a little bit fearful about what 2014 may bring, especially considering we’ve seen quite a few down days on Wall Street.

I’ve suggested that investors carry a long-term diversified portfolio, with cash left over for options, swing trades and market corrections. However, not every investor may feel this way, and sometimes a little hedging can help you sleep easier at night. Here are three strategies if you feel stock prices are at nosebleed levels.

#1 Take Profits

The first and most obvious choice is to just take some profits and/or harvest losses. In my case, I generally reserve these options for my small-cap and midcap stocks, along with whatever swing trades I might have in motion at the time. Many of my long-term core holdings are large cap stocks, and I generally leave those alone.

For example, I cashed out my position in Encore Capital Group (ECPG ) and Portfolio Recovery Associates (PRAA ). I’m very high on both of these companies, but I didn’t like the overall market action lately and these stocks had broken some key technical levels. I’ll buy back in at some point.

Another thing that occurred was I had a trailing stop loss in place for iShares Russell 2000 Value (IWN ). This was set 7% below the closing price from each trading day the stock was up, but stayed in place if the stock went down. So I lost 7% off the stock’s high price, and booked those profits. I also sold Vanguard Health Care ETF (VHG ) for a small loss, which allowed me to offset a bit of the capital gains from the other trades.

Some investors are hesitant to take profits because they fear missing further upside in the stock. But if youre worried about a market crash, better to miss a little more upside than be stuck with a lot more downside.

#2 Buy Puts

Another way to go is to purchase puts against various indices. I don’t particularly care for that strategy, but it seems to work for some investors.

As I write, the SPDR S&P 500 (SPY ) is at about $180. Let’s say I’m concerned about a 20% correction in the next two months. I might purchase the March 180 Put for $4.65. If the market fell 20% right at expiration, then SPY would be trading at around $144, and your put would now be worth about $36.

So if you own $18,000 worth of stocks, you would have just offset that 20% plunge. But remember, you are basically spending about 2.66% of your portfolio for insurance against a 20% plunge that must occur within the next two months, or you lose that money.

This is a riskier way to hedge against a market crash, but its a good way for savvy traders to turn market action in their favor.

#3 Buy Leveraged ETFs

Another option is to do the opposite of what I did late last year. I felt very certain the market would soar in December, so I purchased several aggressive ETFs, including leveraged bullish ones. I made about a 10% return in one month. If things are looking bearish, I might suggest buying inverse index ETFs.

Say you hold $50,000 in the S&P 500, and youre expecting a 20% crash. You could buy ProShares Short S&P 500 (SH ). If you buy $50,000 worth, then you are effectively market neutral. If you don’t want to invest so much, you could use a leveraged ETF, in which case you’ll invest less and see a larger move, but that also means you could lose serious money if you call the market wrong.

This is the riskiest hedge for a market crash, but it also has the highest potential profit. Make sure youre certain that the market is falling before entering any leveraged inverse ETFs.

Its difficult to say for certain where the market is going, but smart investors who pay close attention will recognize the signs. Then you can confidently use these methods to protect your portfolio during a market crash.

Lawrence Meyers does not own shares in any company mentioned.