The US stock markets ended the worst first half in over 50 years in June, pushing the S&P 500 into a bear market, having dropped more than 20 per cent from the January high. Meanwhile, the ASX 200 took the last but hardest hit from the central bank’s ‘front-loading’ rate hikes, plunging more than 10 per cent in one month. Locally, the New Zealand benchmark index, the NZX 50, tumbled 20 per cent in the first half of the year.

It’s certainly a difficult time for investors who hold a bunch of losing positions, and panic selling often happens when the stock market drops. Eventually the markets will bounce back, so this panic selling can lead to unnecessary losses. What tools could you consider as hedges for your current losing positions?

The defensive instruments

If the risky assets account for a large percentage of your portfolio, you could consider increasing your proportion of safe-haven assets. The traditional safe-haven asset is gold, and the price of gold usually increases when there is a market crash or during uncertain events. Physical gold can have a high storage fee, so gold-related ETFs are good alternative investment. Gold-related exchange-traded funds (ETFs) such as SPDR Gold Shares (NYSEMKT: GLD) and iShares Gold Trust (NYSEMKT: IAU) are easy to manage and have low transaction fees.

As shown in the chart below, gold held its value when the SPX 500 crashed during the Global Financial Crisis (GFC), the US-China trade war, and Covid-19.

Utilities and consumer staples tend to be less volatile

In the stock markets, defensive sectors are usually more stable during market turbulence. The typical defensive stocks are in the utilities and consumer staples sectors: businesses in these categories usually endure an economic downfall better as they’re consumer essentials.

ETFs you could consider are the XLU Utilities Select Sector SPDR Fund (XLU) and Consumer Staples Select Sector SPDR Fund (XLP). Both the XLU and XLP outperformed the SPX 500 with the least volatility in the year to date.

Gauging the risks of the market

The CBOE Volatility Index (VIX), which is the index to gauge the risks of the market, is a useful tool for investors to hedge market downturns. The VIX surges when investors show concerns and worry, especially in a market crash. The VIX skyrocketed to above 80 in both March 2020, when a pandemic-induced sell-off happened, and in October 2008 during the GFC. On the flip side, the VIX is usually below 30 when the market sentiment is relatively calmer. It’s also an indicator for investors to assess the market risks.

The instruments to hedge long positions

There are some instruments providing the reverse trending against the mainstream stock markets, too. These products are going inversely with the hedging instruments, such as PSQ or SQQQ to hedge QQQ, SH to hedge S&P 500, SARK to hedge ARK, and BetaShares BBOZ to hedge ASX. However, these EFTs are not buy-and-hold investment instruments, which are usually for one-day hedging purposes. Also, some of the reverse EFTs provide leverage in the pricing movement which, in turn, increases risks when markets rebound. Two of the most popular hedging ETFs are as follows:

ProShares Short QQQ ETF (PSQ), an exchange-traded fund that tracks the inverse of the Nasdaq-100 index ETF (QQQ) daily. ProShares UltraPro Short QQQ (SQQQ) is a three-times leveraged inverse ETF that tracks Nasdaq 100.

ProShares Short S&P500 (SH) goes inversely to the S&P 500, which is good to hedge a bear market daily. ProShares UltraPro Short S&P 500 ETF (SPXU) is times inverse of the S&P 500 performance, also for a one-day hedge.

CFD short sell

Contracts for difference (CFDs) are derivative products that enable you to trade on the price movement of underlying financial assets, which allows both buy- and sell-side trades. Essentially, placing a sell position in a downtrend market can bring the same return as a buy trade in a market rally. For example, you can place a short sell trade for any shares that you hold when they are plunging, to hedge the losses, which is the beauty of having a CFD trading account. When the price falls, a short position will bring gains for the same amount as the falling prices.

However, this requires a personal decision regarding the proportion of your portfolio that needs to be hedged, and the timing of when the hedging positions need to be closed. In a bear market, the short positions usually need to be closed toward the bottom. Traders may sometimes refer to option markets to decide the CFD closing prices. When using a CFD account, you need to manage the leverage risk to avoid a margin call.

Disclaimer: CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction, or investment strategy is suitable for any specific person. The author does own shares in some of the securities mentioned.