MHP Asset

specialized investments • trust services • wealth management

Protecting Profits

February 28, 2007

The U.S. and global equity (stock) markets have had a very good run in the last couple of years. Many market watchers, including myself, believe we are due for a correction or pullback in the markets.

There are several strategies you can employ to protect the gains that you have accumulated in this last bull run. The first and most obvious is to sell your stocks or mutual funds and wait for a pullback, then look for a good reentry point. This strategy will create tax ramifications on your gains if you are in a taxable account. You could also use “stop losses” which is, placing a sell order that would trigger if a stock declined to a certain level.

The second strategy you can do is to buy “put” options on stocks or stock indices. Using options requires knowledge of options and option strategies. There are two components to an options premium (price) which you will pay for, time and intrinsic value. Because options expire at a set time, you must be right when trying to time this potential downturn in the markets. To really explain options, I would need to write a dissertation on derivatives, but I do not believe it is the best way to hedge your portfolio anyway.

The third strategy to protect your portfolio is to sell (short) futures contracts on the equity indices which are traded in the futures markets. These gain value as the stock market or underlying equity indices go down. These futures contracts are very volatile and require margin (deposit) money. The only way I would recommend these futures contracts are to a person or institution with a lot of assets in the markets that understands the risk and characteristics of derivatives like futures contracts.

What I do suggest is to research the exchange traded funds, which are “short the market” in various sectors including the Dow (DOG), NASDAQ(QID), S+P 500(SH) and other represented sectors. Short the market is a term used when you believe that a stock, bond, commodity, futures contract or really anything traded will go down, or becomes bearish.

Using these short indices ETF’s, you will be able to take some risk out of your portfolio without selling current holdings of stock or funds, assuming you are in a stock portfolio or mutual funds that are mostly comprised of stock.

In conclusion, hedging a portfolio takes some time and knowledge. Thus the level of hedging can be minimal, to minimize the negative effect of a downturn on your portfolio, to aggressive, which would be to anticipate the downturn and make money with a market correction. The alternative is to do nothing and hope that the markets do not correct and continue to go up, forever!