By Mike Burnick
After a very long stretch of low volatility in global equity markets, and record low credit spreads in worldwide credit markets, reality rushed back in a hurry in late July. And boy does it sting!
According to Bloomberg, in less than four weeks starting on July 20, global equity markets dumped about US$3.4 trillion in value. The Morgan Stanley Capital International World Index sold off more than 10% since reaching a record high July 19th.
Fixed income markets also tumbled; with the exception of safe- haven buying in U.S. Treasuries and other top-rated bonds, as the market for mortgage-backed securities came to a virtual standstill. Investors who have grown accustomed to one-way bets on the long side of the market got a quick lesson in risk management. Not many asset classes we re spared from the sell off. Global stock and bond markets slumped, and even high-flying commodities got caught up in the selling panic.
This episode makes me thankful for the variety of hedging strategies available to individual investors today — especially using innovative exchange traded funds. On of the most pioneering providers in this realm is ProShares, which sponsors a series of inverse and double-inverse ETFs designed to rise in value when global markets fall.
Yet these securities can be purchased in an ordinary stock brokerage account. In fact, some of these funds give you leverage of 2-to-1 on your money (both long and short) without ever needing to open a margin trading account. Now that’s financial innovation for you!
Exercise Your Option to Hedge
Some of the Pro Shares offerings even let you drill down to specific sectors that you’re bearish (or bullish) on. For instance the ProShares Ultra Short Real Estate ETF (SRS) performed quite well during the stock market sell off. In fact, from mid-July to mid-August, shares of SRS gained about 22% in value, while the S&P 500 tumbled nearly 10% — a terrific hedge against market weakness! (I covered these ETFs, and other hedging options more fully in the A-Letter back in April “How to In vest in Correction Protection for the Next Time Stocks Sell Off.”)
However, in today’s fast-moving and more volatile financial markets, investors should have more investments open to them than ETFs alone can provide. Specifically, stock index options, and even options on ETFs provide a great, low- cost, limited risk, way to hedge your global investment bets.
Even if you don’t consider yourself a market “speculator,” options on popular market indexes and options on ETFs can play a key role in your portfolio if, for no other reason, than to help protect your other holdings from rising volatility in financial markets.
If you’re willing to gamble a bit on headline events that can have a major impact on financial markets, then options can offer you a way to make leveraged investments with really big upside profit potential, while risking very little capital in the process. This kind of leveraged upside earnings power can often payoff in big gains when market shocks occur and volatility spikes higher, as we recently witnessed.
Crisis Ripped Right from the Headlines
Let me give you a recent example, taken straight from recent headlines.
On July 18, 2007, Bloomberg ran the following headline: “Bear Stearns Tells Fund Investors ‘No Value Left.’”
The accompanying Bloomberg article explained that the big Wall Street brokerage firm had two hedge funds go belly up due to steep losses in sub-prime investments gone bad. The two Bear Stearns hedge funds took about US$2 billion worth of investors’ capital down with them. As you could have predicted, other Wall Street firms faced the same problems.
If you owned bank or brokerage shares in your portfolio, or owned mutual funds or ETFs with big financial sector holdings you were probably concerned about what to do. Should you cut and run, potentially triggering capital gains taxes, or stick with your holdings?
What to Do BEFORE Scary Headlines Threaten to Steal Your Profits
Options can make this decision a lot easier.
There’s a popular ETF available — the Financial Sector SPDR (X L F) — that tracks all the major banking and brokerage firms. These big Wall Street players include Bear Stearns, Morgan Stanley, Citigroup, JP Morgan, Goldman Sachs, Merrill Lynch, Lehman Brothers, and others. All the “usual suspects” that you just knew would be vulnerable to the unfolding sub-prime induced credit crunch. Sure enough, within weeks, Citigroup admitted to US$700 million in credit market losses, while JP Morgan fessed up to a US$1.4 billion loss on leveraged buyout loans.
But purchasing put options on the Financial Sector SPDR ETF (XLF), could have insulated your current holdings from this decline; or these options could have earned you big profits during the market shock as the underlying index or security — in this case the XLF — plunged in value.
In fact, you could have purchased XLF August US$35 put options in mid-July for just US$25 per contract. By August 1st these options contracts jumped to US$185 in value — for a gain of 640% in just a few short weeks.
Naturally, not all option trades work this well. Options can be risky bets if you don’t know what you’re doing, but the risk is always limited to just the amount you invest – not a penny more. Whether used to protect your holdings, or for the sheer leveraged profit potential, options can be a powerful investment tool for your arsenal.
Mike Burnick serves as a Senior Editor and Global Markets Analyst for The Sovereign Society. He edits his own signature investment research service that focuses on worldwide ETF profit opportunities: Global Market Investor. Today, Mike uses his 20 years of experience in the investment industry, to research the global financial markets and emerging investment trends worldwide.