The 5 Best Hedges for a Drop in the S&P 500

When stocks encounter a significant correction or long-term bear market, the writing is frequently on the wall many weeks before. While mean reversion usually means that small losses reverse themselves, every large loss starts as a small loss. Red flags from trade signals can help investors know when to consider downside hedge protection. The best hedge often depends on how early the investor senses danger.

1. Buy VIX Calls

The VIX Index measures the market outlook for volatility implied by S&P 500 stock index option prices. Markets often become more volatile before they crash, and brutal market downturns almost always bring an additional surge in volatility. That makes going long volatility a logical tactic. There are a couple of methods to accomplish this, and the first is to buy VIX call options listed on the Chicago Board Options Exchange (CBOE).

The calls typically rise along with the VIX Index, and it is crucial to select appropriate strike prices and maturity dates. For instance, a strike price that is too far out of the money accomplishes nothing and the premium is lost. Be aware the calls are based on VIX futures prices, and call prices do not always correlate perfectly with the index.

The second approach is to buy into the iPath S&P 500 VIX ST Futures ETN (VXX), but it is burdened with performance issues. It is an exchange-traded note (ETN)—not an exchange-traded fund (ETF). Like the VIX call option, it is based on VIX futures. That leads to some quirks. For example, VXX can move in the same direction as the S&P 500. However, many people expect it to move in the opposite direction. VIX calls are a better choice to hedge by going long on volatility.

2. Short the S&P 500 or Buy Put Options

There are several ways to hedge the S&P 500 directly. Investors can short an S&P 500 ETF, short S&P 500 futures, or buy an inverse S&P 500 mutual fund from Rydex or ProFunds. They can also buy puts on S&P 500 ETFs or S&P futures. Many retail investors are not comfortable or familiar with most of these strategies. They often choose to ride out the decline and incur a large double-digit portfolio loss.

One problem with the put option choice is that option premiums are pumped up with the increased volatility during a major decline. That means an investor could be right on direction and still lose money. Selling short is probably not appropriate for an investor who is only casually involved in the markets.

The first key to making the short approach work is buying right before a decline. Shorting and put buying have the great advantage of allowing investors to profit directly from a drop in the S&P 500. Unfortunately, that also gives them the disadvantage of losing money when the S&P 500 goes up, which it usually does. The other key to successful shorting is to get out quickly when the market goes up.

3. Raise Cash in the Portfolio

Many investors are reluctant to sell because of tax implications, but they lost substantial amounts in the 2008 and 2020 bear markets. They needed large gains later just to break even. One way to reduce the tax bite is to offset profitable stock sales by selling losing positions. Raising cash does not have to be an all-or-nothing decision.

Jesse Livermore talked about "selling down to the sleeping level" when he worried about losses in his portfolio. If an investor is fully invested in stocks, raise cash to 20%, 30%, 40%, or whatever feels necessary. Some choose to sell everything and wait for the smoke to clear. Another tactic is to place trailing stop-losses on stocks, so profits accumulate if the stocks continue to defy the broad market and go up. The stop-loss removes the position from the portfolio if it goes down.

Livermore also said there's a time to go long, a time to go short, and a time to go fishing. Cash is the place to be when it's time to go fishing. That usually happens when the Federal Reserve repeatedly raises interest rates, which prevents most asset prices from rising. Since the Fed doesn't want to crash the market, they'll stop hiking rates before anything falls too far.

So there's no money to be made shorting the S&P 500 either. Just sit back, relax, and enjoy higher interest rates in the money market. The other reason to be in cash is to cut losses during an unexpected decline. The long-term returns of cash are low, but that is better than the negative returns of short-selling the S&P 500.

4. Long-Term Treasury Bonds

In a full-fledged selling panic, investors utilize the flight-to-quality or flight-to-safety move into Treasury bonds, usually after it is too late. Many people swarm into cash, then start worrying about returns and buy Treasuries for their yields. It seems silly to follow the herd mentality into Treasuries as they are becoming overvalued. However, it works if a trader has the sense to get in right after stocks crash.

The main reason to buy long-term Treasuries, especially Treasury zeros, right after an S&P 500 crash is the Fed. The Fed often cuts interest rates and buys up Treasury bonds after a major market decline to prevent deflation, reduce unemployment, and stimulate the economy.

When the Fed takes aggressive actions like that, Treasury bond prices go up substantially. Treasuries also usually rally after a year of repeated interest rate increases come to an end. Treasuries have decent long-term returns, though the low interest rates in the early 21st century suggest lower returns in the future.

5. Go for the Gold

Investors who stayed in stocks during the initial crash and missed out on the rally in Treasuries can still hedge against further declines in the S&P 500 with gold. Gold doesn't always go up in the middle of a crash, but it tends to pick up in long bear markets. In particular, gold went up substantially during the high-inflation 1970s and the 2000 to 2010 lost decade in the United States.

Gold holds its value in the long run and tends to produce the type of performance that stock investors expect when it’s on a roll. Gold often sees solid returns during bearish decades, when few stocks can match that performance. While gold also crashes, it is much less risky and far more rewarding than shorting the S&P 500 in the long run. Finally, there are plenty of gold ETFs available for investors who don't want to buy and hold physical gold bullion.

How to Weather the Storm

Market turbulence is part of the investing game and never goes away. When the storm is approaching, investors should arm themselves with effective hedges until better days return. Investors don't have to become speculators to use hedges.

Buying and holding Treasuries and even gold along with stocks notably reduces portfolio volatility with only slightly lower returns. Although put buying loses money in the long term, buying a put for a few months can also help some stock investors stick to their plans. Hedges help investors create asset allocations that achieve their goals with less stress.

The Bottom Line

Hedging is a necessary part of portfolio management. Whether you're trading on your own or you have a professional, it's always a good idea to monitor your portfolio to see where you can make adjustments. Consider one or more of the steps noted above if you're tracking the performance of the S&P 500 to help you manage your risk and potentially minimize your losses. Just remember, there is no guaranteed strategy that will work to eliminate the risk completely. When in doubt, consult a financial professional to help guide you.