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How to Hedge
Are you Ready for a Stock Market Crash?
Last Updated on January 26, 2023 by Mark Ursell
This article looks at how you can prepare yourself for a future stock market crash. I look at what has happened in the past and what you can do now to protect your portfolio – whatever the markets do.
You can get more details and see me demonstrating the results in the Accompanying Video below.
Table of Contents
January 2008
Fear was stalking the financial markets of the world.
This was the time of The Big Short. American subprime mortgages were becoming toxic. Northern Rock, a British bank, founded in 1850, suffered a run on deposits and needed a bailout. The evening news was showing pictures of people lining up to get their money out.
People had started to lose their homes and their jobs. Unemployment was climbing. By the end of 2008, most countries around the world would be in recession. The number of people out of work in the US was about to double. In the European Union, it would hit 12%.
What were the Consequences for Stock Markets?
For investors it was brutal.
From the January 2008 until March 2009, the S&P 500, the Dow Jones and the Russell 2000 index of small-cap stocks would each lose 55% of its value. Nothing was spared. The Nasdaq 100 lost about 50%, and many stocks went to zero.
If you were invested in the S&P 500, you would have to wait five years until January 2013 before your portfolio recovered.
Will it Happen Again?
History tells us that the stock market has always experienced boom and bust.
Apart from the recent financial crisis, there have been many other crashes.
The Roaring Twenties ended with the 1929-32 stock market fall. The Oil Shocks of the 1970s caused the Dow Jones to fall over 45%. The Dot Com Bubble and subsequent crash saw the Nasdaq fall by over 80%
As prudent traders and investors, we should assume that the stock markets will crash at some time in the future.
Can You Avoid a Market Crash?
During a market crash, you can either wait until the market recovers or hedge your portfolio.
Both of these options have advantages and disadvantages.
Buy and Hold or Hedge?
| Buy and Hold | Hedged Strategy | |||
|---|---|---|---|---|
| Advantages | Disadvantages | Advantages | Disadvantages | |
| Never miss a recovery | Drawdowns | Reduce Drawdowns | Cost | |
| Ignore marketgyrations | Gives you flexibilty about when you can withdraw your capital | Can reduce overall profitability | ||
| Reinvest dividends over the maximum amount of time |
Analysis
To understand which method is best I have carried out an analysis to compare buy-and-hold with three different hedging strategies. I want to understand whether we should be hedging and if so, which is the best way to hedge.
Market
I’ve used the SPY SPDR S&P 500 ETF. One of the oldest exchange-traded funds. This is a long-term analysis, and I have included reinvested dividends.
Time Period and Timeframe
1993-2018
Daily Timeframe
Method
I have used a Tradinformed Backtest Model. This model has been specifically set up to test hedging strategies. Tradinformed Backtest Models can make your trading life easier and more profitable. Click here to Learn More
Hedging Strategies
Buy and Hold
Buy at the beginning of the period and hold until the end.
Sell below the 200 period EMA
Hedge or sell out of portfolio when the price is below the 200 EMA.
Golden Cross
Hedge or sell out of portfolio when the 50-period EMA falls below the 200-period
Linear Regression
Hedge or sell out of portfolio when the 200-period linear regression is pointing downwards
Results
| Metric | Buy-and-Hold | Hedge below EMA | Golden Cross | Linear Regression |
|---|---|---|---|---|
| Gross Winning Trades | $810,198 | $820,820 | $1,014,100 | $1,013,353 |
| Gross Losing Trades | $- | $-264,751 | $-89,593 | $-19,448 |
| Net Profit | $810,198 | $556,069 | $924,508 | $993,905 |
| Profit Factor | #DIV/0! | 3.10 | 11.32 | 52.11 |
| Winning Trades | 1 | 20 | 7 | 8 |
| Losing Trades | 0 | 66 | 3 | 1 |
| Percentage Winning Trades | 100% | 23% | 70% | 89% |
| Average Winning Trade | 810,198 | 41,041 | 144,871 | 126,669 |
| Average Losing Trade | #DIV/0! | -4,011 | -29,864 | -19,448 |
| Largest Winning Trade | $810,198 | $165,583 | $342,560 | $281,234 |
| Largest Losing Trade | $- | $-11,281 | $-84,470 | $-19,448 |
| CAGR | 9.2% | 7.8% | 9.8% | 10.1% |
| Max Drawdown | 55% | 26% | 19% | 19% |
Conclusion
The results above strongly suggest that it is a good idea to hedge your portfolio during a market crash. The results show that it is better to invest in the market during most periods. However, when a serious market crash arrives, it is better to be out of the market.
Video
Check out the accompanying video to see me demonstrating the strategies and learn more.
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