Short and leveraged trackers can provide some protection in the short term.

How can you protect your money from stock market danger — and potentially even benefit — if the market plummets?

A good adjustment of 10 to 30% is what I mean by “tank.” It’s worth considering since, in my opinion, this scenario is becoming more plausible, if not probable, by the day.

Market experts have long warned individual investors about the dangers of trying to time the market, but people are left wondering what they can do when they consider what so many market observers are saying: that US investors, in particular, are ignoring some increasingly obvious warning signs about the end of quantitative easing, inflation, and China’s problems.

Spread betting offers a variety of leveraged, or geared, ways to play market ups and downs, but they come with a number of drawbacks that make them a no-no for me: you have to open and fund a separate account, you can’t use a tax wrapper like an Isa, and unless you plan carefully, you could lose more money than you put in.

Short and leveraged (S&L) trackers are another option. These follow key indices and boost returns on the upside (leveraged) by one to three times the daily return, while lowering returns on the downside (short) by the same amount. Many of the major ETF issuers, such as WisdomTree, Deutsche Bank, and Legal & General Investment Management, are involved in the S&L space.

Anyone discussing these products, which measure daily returns, has traditionally issued a health warning — since if you stay in them for more than a few days, you risk substantially destroying your fortune.

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Consider an index that starts at 100 on the first day. It decreases 5% by the end of the day, then climbs 5% on day two, falls 5% again on day three, then rises 5% again on day four. At the conclusion of day 4, you don’t actually get back to 100%; the ultimate figure is 99.5 percent. The leveraged 3x tracker and the short 3x tracker, on the other hand, both complete day four at 95.55 percent.

The daily volatility accumulating is a killer. When we get to the weeks and months, the consequences can be disastrous. It’s no surprise that these items have been labeled as only acceptable for day traders.

It doesn’t have to be that way, though. If you wish to hedge a portfolio over weeks or even months, S&L products can be a lifesaver. Markets don’t always bob up and down at random. They follow a pattern, however there are variations within that pattern.

Why? Because investors are prone to switching from bull to bear based on market narratives that tend to linger for long periods of time, they are like a madding throng (by that I mean weeks and even months). Let me illustrate with some numbers.

Some of the previous major sell-offs — September 2020, February 2020, Autumn 2018 and July 2015 — were barely blips on the radar. The S&P 500, for example, was down just under 10% in September 2020. Others, on the other hand, were serious blowouts of 20 to 30%.

In each case, if you had purchased a short leveraged tracker on the S&P 500 at a bullish high and then sold at a bearish low, you would have profited handsomely (and spectacular losses with leveraged version).

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That kind of foresight, on the other hand, is completely inconceivable. So I went back and looked at a longer time frame, usually three weeks before the bullish high and a few weeks after the bearish low.

With the exception of September 2020, you’d have made decent gains or lost a percentage point or two (in 2015-16).

Short and leveraged trackers have a lot of value.

Take the month of February 2020. The S&P 500 reached a bullish peak around February 21 and a bearish low around March 23. During those four weeks, the S&P 500 dropped by a scary 33%. In comparison, LGIM’s 2x time short tracker increased by 86%, while WisdomTree’s 3x tracker increased by 132%.

But what if you had purchased the same short trackers on February 1 and sat tight until April 2020, when markets were aggressively rebounding?

The conventional forewarnings would have predicted tragedy. In reality, both the 2x and 3x cases generated gains of 30 to 35 percent. Clearly, if you had waited until mid-April to sell, when markets were truly raging, you would have made a lot more money, you’d be throwing good money after bad, but my point remains the same. These daily trackers can be used for weeks or even months.

Consider the inverse scenario: bullish markets, where the trend has been steadily strengthening over the past year. S&P 500 is risen roughly 31.7 percent in the year through October 25th, 2021. However, LGIM’s 2x leveraged (bull) tracker is up 74.4 percent, while WisdomTree’s 3x tracker is up 123 percent. Even shifting the start dates by a week or two does not make a significant impact in terms of returns.

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So the trick is to keep an eye on the market’s mood and make sure you aren’t too late to a significant shift in sentiment. It’s also a good idea to keep an eye on your tracking index. Consider the precious metal gold. We’ve all been conditioned to believe that gold is a safe haven asset that will perform well when markets are volatile. As a result, one may expect a gold leveraged short tracker to do well during market turbulence. Regrettably, the numbers indicate otherwise. Only the market turbulence in September 2018 brought some respite.

In a market panic, a riskier index might sell off more aggressively. The FTSE 250 contains far smaller companies than the FTSE 100 in terms of market capitalization, and it was down 40% in February of last year. From peak to trough, WisdomTree’s 1x short on this index rose in value by roughly 60%. Even if you added a few weeks on either side, you’d still have profited 40%.

Short and leveraged trackers can and have made sense for the daring investor who understands the risks and is willing to consider short term — but not become a day trader. Simply proceed with caution.

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