Hedge Against a Crash Now

The S&P 500 is in bear market territory, down 20% since last October, and a recession looms on the horizon. The outlook hasn't been this uncertain for years. It might seem like a good time to sell and just wait out the volatility, but then you'd miss out on any big bounces.

So instead of running away, you should consider hedging your portfolio. A good hedge can reduce your downside risk, while keeping most of the upside.

One hedging option
One way to hedge is using put stock options. Suppose that you like Mosaic Company (NYSE:MOS), but you're worried about short-term risks. The stock has enjoyed a big run-up, and you don't want to lose your gains. But you also don't want to sell the shares, because you still believe in the agricultural boom and that Mosaic can go even higher.

To hedge, you could buy puts. The owner of the put has the right to sell the stock at a predetermined price for a period of time. On July 16, with Mosaic at $138, you could buy the September $140 put for $16.20. Then, if the stock's trading at less than $140 anytime between now and the third week of September, you could either sell the put or exercise the put and sell the stock for $140. If, instead, Mosaic appreciates, you would elect not to exercise the put (why sell for $140 if the stock's trading for more than that?).

The great thing about hedging with puts is that you limit your downside risk but keep the huge potential upside.

Of course, the $16.20 that you pay for the put will come out of your profits. What's more, the more volatile the stock -- and the more you need insurance -- the more you'll pay for the option:

Prices as of July 16, 2008, courtesy of thinkorswim.

So right now, the market thinks that retail and investment banks burdened with mortgage debt are riskier than two consumer staple icons of American industry that have accepted all-cash takeover bids. No kidding.

Avoiding expiry
The big problem with puts is that they're like term life insurance. You pay a premium to be insured for a few months, but when that time period is done, your insurance and premium are gone. However, there is a way to hedge without worrying about your hedge expiring.

You may have heard of the iShares MSCI EAFE (NYSE:EFA), an exchange-traded fund (ETF) that mimics the performance of the MSCI EAFE (Europe, Australasia, Far East) foreign stock index. Well, there are short ETFs, too, whose performance is the inverse of the corresponding index. 

Even better, there are the UltraShort ETFs, which return twice the inverse performance of the underlying index. If the MSCI EAFE falls 1%, the UltraShort MSCI EAFE ProShares (EFU) gains 2%. Thus, UltraShort ETFs give you twice the protection for your hedging dollar.

These funds are great at guarding against a decline in the general market or a specific sector. But there are two downsides. First, if the market goes up instead of down, your hedge will lose money. Second, these ETFs maintain constant leverage. Mathematically, that means that if the underlying index goes up 10 points, and then down 10 points, the UltraShort fund won't break even. It will lose money.

The hedge-less hedge
Perhaps the best way to hedge is to not hedge at all. The reasoning is simple: Whenever you buy a stock, you should pay less for it than it's worth. Otherwise, why bother? But when you pay less than a stock's worth, it provides you with a margin of safety -- over the long term, stocks generally return to their fair value. So if you buy a stock that's 50% undervalued, then even if its fair value plummets by 50% as the business weakens during a recession, you'll still probably break even over the long term.

Even better, undervalued stocks can give you excellent returns without any improvements to the business. If a 50% undervalued stock just returns to fair value, you have a 100% return.

For example, in the February issue of Motley Fool Inside Value, lead advisor Philip Durell recommended a "truly remarkable franchise." He believes the stock will double in three years, partly because of its superior growth opportunities, but mainly because the shares are extremely undervalued right now.

The Foolish bottom line
So if your portfolio consists of cheap stocks and you have the stomach to stick with those stocks even if they fall further, it may be better not to hedge at all. The strategy you already employ offers an excellent combination of low risk and high reward.

If you're looking for bargains, our Inside Value newsletter service focuses exclusively on such opportunities. You can read all of our recommendations with a 30-day free trial.

This article was first published March 5, 2008. It has been updated.

Fool contributor Richard Gibbons loves to have his cake and eat it, too. He owns none of the companies mentioned. Anheuser-Busch is a former Inside Value pick. The Fool's disclosure policy dreams of one day being a real boy.