Is The Correction Over?

Federico is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Nobody knows if the 11-session, 5.27% S&P 500 decline from the high of 1687.18 on May 22 is over or not. The easiest way to figure it out is to look at the cold data relating to all past corrections in the market greater than 5% to determine the odds that the current sell-off is at an end.

History shows that the median 5%+ correction since 1927 is -8.31%, while the mean 5%+ correction is -12.21%. The data points are many--since 1927, there have been 206 corrections of 5% or greater. History shows that once you're down more than 5%, you end up going down further. And there's also the matter of duration. The current 5.27% sell-off has been running for 11 sessions, a mere two weeks in the making. By comparison, the median 5%+  correction since 1927 unfolded over 23 days, while the mean 5%+ correction took 42 days to run its course. Hence, by the historical approach, the answer is that it is unlikely that the sell-off is over.

Then, if your net portfolio is long in equities, it might be wise to hedge your position. Here I present three assets you might buy in the market that could help your portfolio when the market is going down. 

Going long volatility

iPath S&P 500 VIX Short Term Futures (NYSEMKT: VXX) is an ETF which offers exposure to a daily rolling long position in the first and second month VIX futures contracts. The VIX contracts reflect the implied volatility of the S&P 500 Index. Being down by 38% Year To Date (YTD), the ETF will go up when volatility spikes, which is (almost always) when equities go down. The fund pays a 0.89% yearly fee, and it's a fair way to protect your portfolio when you expect volatility in the markets. The ETF's beta with the market is -300% (it moves with 3x the S&P500's volatility). That said, betting on the market's volatility is not the same as betting on the market going down in price. Even if those two things are highly correlated, they are not the same thing. 

There are other instruments that are better when your final aim is just protecting your portfolio from a general market decline. My favorite choice is the ProShares UltraShort S&P500 (NYSEMKT: SDS). This ETF is a fund that intends to replicate 2x the inverse performance of the S&P 500. Hence, its theoretical beta should be around -200%. Trading at a 0.75% discount to NAV and with a 0.89% expense ratio, this ETF is useful for those trying to protect their portfolios from overall market risk.

Another useful instrument with less volatility than the one just mentioned is the ProShares Short S&P500 (NYSEMKT: SH). This ETF is supposed to behave in the opposite direction of the S&P 500. With a yearly expense ratio of 0.89%, trading at 1x NAV and with a theoretical beta of -100%, this is the first hedge instrument that comes to mind when thinking of a general market correction. This ETF should be used by people who have diversified portfolios within US large cap companies and do not wish to be over-exposed to the losses or gains the swaps that conform short and ultra-short index funds are composed of. As a matter of fact I would recommend holding the ProShares Short S&P 500 over the ProShares UltraShort S&P 500 when you want to be hedged for more than just a few months. If you want to be tactically hedged, use the ultra-short ETF. If you want to be hedged for a longer period of time, just use the simple short instrument.

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Federico Zaldua has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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