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4 Portfolio Strategies for a Volatile Market

4 Portfolio Strategies for a Volatile Market
Ron DeLegge, Editor
March 25, 2009

SAN DIEGO (ETFguide.com) – After experiencing all of the ups and downs of the stock market, do you ever get the feeling like you’re on a ship that’s about to sink? If so, you’re not alone.

As of late, we’ve seen volatile stock trading sessions with one day percentage swings between 1 to 5 percent. In the past that may have seemed abnormal, but it’s become today’s new normal.

In a little more than one month, we’ve seen the Dow Jones Industrial Average (NYSEArca: DIA) trade down to 6,440 from 7,550 and then rebound to 7,800. The S&P 500 stock index (NYSEArca: SPY) went from around 800 down to the forsaken 666 number and then up to 823. Interestingly, the NASDAQ Composite Index (NasdaqGM: ONEQ) which is typically the more volatile stock index of the three has been the most stable. The NASDAQ’s good performance is largely due to recent rise in technology stocks (NYSEArca: XLK). 


To get a better handle on how much stocks are moving up and down, there are financial tools to help you. The VIX index, which is also known as the “fear indicator”, measures the implied volatility of the S&P 500. After touching an elevated reading of 80.86 back in late November, the VIX has subsequently declined by 50%. The current VIX reading is around 40. 

Here’s four portfolio strategies for successfully dealing with volatile markets:

Limiting Your Downside
Stop/Loss orders are a popular technique for limiting your downside exposure. For example, if you bought the SPDR Gold Shares (NYSEArca: GLD) at a market price of $90 per share you may decide to place a 5% or 10% downside floor on your purchase. The idea is to prevent market losses from becoming larger than you want.

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A stop order to buy or sell an ETF happens at the market price once the ETF has traded at or through your specified price. (Also known as the “stop price.”) The advantages of stop orders is they act as an automatic trigger for an order entry or exit once a certain price level has been achieved. The disadvantages are your order may get filled at a much higher or lower price than the ETF’s price, especially in fast moving markets. There are also variations of stop/loss orders too, such as stop limits.

Hedging Your Positions
ETFs are effective hedging tools for managing risk. For example, investors can guard against over-concentrated equity positions by using ETFs as single stock substitutes. Dan Dolan, Director of Wealth Management Strategies at the Select Sector SPDRs suggests asking a few basic questions. “Will your ETFs be a stock or mutual fund alternative, a core position or a satellite position? Are you increasing or decreasing the overall risk in the portfolio?” Dolan encourages investors to look at how sector ETFs can help them to hedge and even execute various portfolio strategies. 

In the February edition of our ETF Profit Strategy Newsletter we assembled a list of “50 Blue Chip Stocks and their ETF Replacements.” We matched up stocks with their corresponding ETFs by market size, market orientation, and industry sector. The idea of using ETFs as stock or mutual fund replacements can reduce risk and volatility by letting you diversify away from large equity or fund positions. Another hedging technique is using inverse performing or short ETFs to protect against a market decline.

Sector Rotation
Convenient market exposure to various industry sectors is readily obtained with ETFs. For example, if you’re bullish on healthcare stocks, you can overweight the S&P healthcare sector (NYSEArca: XLV) within your portfolio. Conversely, if you’re bearish on utility stocks (NYSEArca: XLU) you can underweight or avoid this sector.

By tactically shifting assets, you can over and underweight specific sectors according to their financial research, economic outlook, or market objective. Owning or selling concentrated business segments allows ETF investors to capitalize on both positive and negative sector trends.

Using Call/Put Options on ETFs
After hearing the word "options" some investors are scared off. Unfortunately, many people have been misled or given an inaccurate view of options. The bottom line is this: Options are merely financial tools that can help ETF investors to manage risk and to possibly even bag some profits.

One commonly used options strategy is to purchase protective put options. This allows an ETF investor to protect their long ETF positions and to offset any potential market declines. In the March and April editions of our ETF Profit Strategy Newsletter, we highlighted four key ETF options strategies. We explained the basics of how call/put options work and gave specific examples of ETF option strategies executed.

Executing Your Strategies
Exchange-traded funds allow you to execute portfolio strategies that help you to reduce the volatility of your investment portfolio. The exact portfolio strategies you decide to use will largely depend upon your unique investment goals, tolerance for risk, and your investment time horizon.

Some of the strategies mentioned above are not possible to execute with traditional mutual funds. For example, mutual funds do not offer intraday liquidity and can only be bought/sold at the fund’s net asset value (NAV) price. On the other hand, ETFs do have intraday liquidity and can be bought/sold at whatever market price they’re trading at.

The financial flexibility of ETFs is one of their greatest strengths. It’s also one of the reasons more and more investors are turning to ETF investing to reach their investment goals.

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