How to Hedge a Bad Market

If you're on the right side of the market red can be a good colour.

According to Reuters, this weekend Spain is expected to ask the euro zone for help with recapitalizing its banks. Spain will be the fourth nation in the euro zone to seek a bailout since Europe’s debt crisis began.

First, Ireland received an 85 billion euro bailout package in November, 2010. Then in May, 2011, Portugal received a 78 billion euro bailout while Greece, throughout the crisis, has been receiving ongoing support.

Senior EU and German officials confirmed that the deputy finance ministers from the single currency area would hold a conference call on Saturday morning to discuss a Spain’s request for aid, although no figure for the assistance has yet been fixed.

Later the Eurogroup, which consists of the euro zone’s 17 finance ministers, are expected to hold a separate call to discuss approving the request.

The news today comes after Fitch Ratings cut Madrid’s sovereign credit rating by three notches to BBB citing the Spanish banking sector’s exposure to bad property loans and contagion from Greece’s debt crisis as the reasons for the decrease.

Fitch estimates Spain will need at least 50 billion euros in capital to shore up its banking system and as much as 100 billion euros (9 percent of Spain’s GDP) under a more extreme scenario similar to that of Ireland in 2010.

When it was reported that Portugal would received a bailout last year the financial community’s response was positive to the news and both the euro and the European markets rallied. Can we expect a similar rally this time? Perhaps, but with the Greek election slated for June 17th more uncertainty is right around the corner and it’s a guess which direction the markets will go.

In volatile bear markets there are a few ways for investors to protect their wealth. A move out of equities and into bonds (preferably not Greek bonds), a move into cash and “sit tight” or, for investor with more appetite for risk, buying exchange traded funds (ETFs) that are inversely correlated to the markets.

Many investors also consider gold and silver as a “safe haven” and a “crisis hedge” but we tend to look at precious metals as a fiat money “liquidity hedge”.

ETFs are investment funds traded on stock exchanges, much like a stock. ETFs hold assets such as stocks, commodities, or bonds, and trade close to their net asset value over the course of the trading day. Many are tracked to indexes like the DJIA or the TSX. Inverse ETFs are negatively correlated with price movements so they will increase in price when their corresponding assets decrease in price.

Specific examples of actively traded ETFs in Canada that go up when the markets go down are Horizons Betapro S&P/TSX-60 Bear Plus 2x leveraged ETF (TSX:HXD) and the Horizons Betapro S&P 500 VIX Short Term Futures ETFs (TSX:HUV). And if you really want a wild ride, there is a 2x leveraged version of “HUV” which trades under the symbol “HVU”.

For a complete list of ETFs in Canada – CLICK HERE.

In the U.S., the ProShares Short S&P 500 trades under the symbol “SH” while the iPath S&P 500 VIX Short Term Futures ETF trades under the symbol: “VXX” on the NYSE Arca. iShares is the largest issuer of ETFs in the United States and globally. SPDR (known as “spiders”), ProShares and PowerShares are also well know families of ETFs.

To hedge a bad market – CLICK HERE – for a list of inverse ETFs in the United States.

Note:

The volatility index (US symbol: VIX) is commonly known as the “fear index” because a high VIX represents uncertainty about future equity prices. The index is calculated by the Chicago Board Options Exchange using the price of near-term options on the S&P 500 index. The VIX is volatile and has a high negative correlation with the S&P 500 Index – for more on the VIX – CLICK HERE.

By Matt Earle

Matthew Earle is the Founder of MiningFeeds. In 2005, Matt founded MiningNerds.com to provide data and information to the mining investment community. This site was merged with Highgrade Review to form MiningFeeds. Matt has a B.Sc. degree with a minor in geology from the University of Toronto.

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