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Protect Yourself From Unknown Unknowns With ETFs

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Investors usually focus their risk management on the hazards they know about. However, it's frequently the risks we don't see that pose the biggest threats to our portfolios.

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Investors usually focus their risk management on the hazards they know about. However, it's frequently the risks we don't see that pose the biggest threats to our portfolios. Luckily, we have ways to protect capital.

In 2010, it was the "flash crash" that sent markets spiraling down 17%.

In 2011, it was the debt ceiling debacle and the corporate fraud of MF Global that sent markets down over 20%.

This was followed up in 2012 by Knight Capital's (NYSE:KCG) $440 million trading "glitch."

And just the other day, we had a mini flash crash on the S&P futures all because of a false tweet from a news outlet.

How many of these events were predicted? (The answer is none.)

As if investing wasn't already difficult enough, it is the things we don't know, the "unknown unknowns," that can really hurt us. We call them rogue waves.

As the examples above demonstrate, not having protection in this environment is downright dangerous. Luckily we have some options.

A Look at the Most Recent Rogue Wave

Before we talk about the recent mini-flash crash, here's a quick recap about the significance of rogue waves (sometimes referred to as "Black Swans"):

Rogue waves (also known as freak waves) are large and spontaneous ocean surface waves that occur at sea and are a threat even to very large ships and ocean liners. In oceanography terms, any waves whose height is more than twice the significant wave height (SWH), is considered rogue. Interestingly, rogue waves are not necessarily the largest waves found at sea, but instead, unexpectedly big waves for a certain ocean atmosphere. Furthermore, exceptionally large waves are often caused by a conglomeration of factors, rather than just one.

Rogue waves don't just exist in nature, but in financial markets, too. Unexpectedly big waves that occur given a certain, usually relaxed, atmosphere.

On Tuesday April 24, at 1:09 p.m. eastern time, the markets (NYSEARCA:VTI) plunged on the back of a "hacked" Tweet from the Associated Press. This was a financial rogue wave.

Within a few minutes, the S&P 500 (NYSEARCA:SPY) was down over 1% instantly wiping out over $130 billion in wealth. The chart below captures that moment. Needless to say, no one expected such an event.



This time the markets quickly corrected, and the wealth was regained. But the bigger questions should be, what if next time the markets don't snap back so effectively? Or what if the rumor was actually true? Portfolio protection is definitely needed to mitigate such risks.

"The Unknown Unknowns"

One of our firm's "Mega Investment Themes" has been protection from rogue waves. In this day and age of extremely high correlations, there is a greater potential for unforeseen (and even unrelated) events to affect your portfolio. We will never know exactly what they are, but we do know they will occur.

This is why we have been big advocates of buying portfolio protection during times of low costs and high complacency. The most recent was in late as March when the VIX (INDEXCBOE:VIX) was trading at 11.30.

On March 17, we identified the high level of complacency (and increased levels of risk) shown by historically low volatility (NYSEARCA:VXX), historically high levels of "dumb money" speculative buyers, and extreme levels of bullish sentiment (NYSEARCA:VIXY).

All of these were signs that the market was ripe for a surprise, which indeed occurred in mid-April as the markets pulled back 4% and the VIX shot up to 18 by mid-April (up 50%+ from our March suggestion).

We also were advocates of buying the VIX on January 23 when the VIX was at 12.46 as well as throughout December when we suggested, "Buying below 16 and certainly below 15 remains a good strategy to hedge your portfolio or capitalize on volatility." Each of these instances saw a VIX (NYSEARCA:UVXY) spike to at a minimum the upper teens.

The chart shown below provided to subscribers on 3/17 highlights some of the long VIX recommendations over the past year (red arrows). Using technical analysis and relative strength techniques we have been able to identify ideal times to hedge your portfolio from known and unknown risks by buying volatility options and ETFs when they were cheap.



What Next?

The rogue wave from April 23 is just one example of an infinite amount of unknown unknowns that can affect your portfolio adversely. Using our technique of buying volatility calls would have protected you during the recent flash crash as the VIX and its ETFs rallied over 8% that day as the final chart shows.

Many volatility options shot up over 100% in that few minute period, certainly protecting, but also allowing investors to profit from rogue waves.



We certainly will never know all the unknowns out there, but that doesn't mean we shouldn't try to protect our portfolios from such unpredictable events. VIX call options and various exchange-traded products can be used to help hedge downside risk. (But beware of some of the risks of Volatility ETPs).

It also doesn't mean we should just buy the VIX blindly. Just as with any investment, there are better times to buy than others.

Editor's note: This story by Chad Karnes originally appeared on ETFguide.com.

To read more from ETFguide, see:

Are Defensive Sectors Still Defensive?

Hedging the Most Actively Traded ETFs

5 Attributes Top Traders Have in Common
No positions in stocks mentioned.
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