How to limit your losses in an economic crisis?

The famous saying goes that hindsight is always 20/20. This is also true for investing moreover in times of economic crisis. Probably every investor has at some time or other questioned his or her conscience for not selling a stock in time to avoid big losses. With hindsight, it is easy to say how an investor should have acted to avoid losing money in a crisis. However, timing the market is very difficult. So let's look at a few strategies that can limit the amount of an investor's loss or even lead to a potential profit during an economic crisis.

Hedging as an “anti-crisis” method

We have already published an article the VIX index, which measures fear and volatility in the US stock market, here. We also mentioned that the VIX index can be used as a hedge instrument when investing in US stocks or the S&P 500 index directly. In fact, there is an inverse relationship between the VIX and the S&P 500 - when US equity indices are rising and the outlook for the future is also positive, the VIX index will fall. When the outlook is negative due to an impending recession or geopolitical instability, the VIX index will generally rise. It should be remembered that the VIX is a forward-looking index - it does not measure actual fear and volatility, but only expected fear and volatility.
Traders can thus use this inverse relationship as a form of hedging or speculation. The ideal instrument is futures contracts on the VIX, which can be traded using CFDs, options or ETFs.


CFDs on VIX and S&P 500 index

O indexu VIX, který měří strach a volatilitu na americkém akciovém trhu, jsme již psali zde. Okrajově jsme také zmínili, že index VIX je možno využít jako hedging při investici do amerických akcií nebo přímo indexu S&P 500. Mezi indexy VIX a S&P 500 totiž platí inverzní vztah - v okamžiku kdy americké akciové indexy rostou a výhled do budoucna je také pozitivní, bude index VIX klesat. V okamžiku negativního výhledu způsobeného blížící se recesí nebo geopolitickou nestabilitou pak index VIX zpravidla roste. Je nutno připomenout, že VIX je výhledový index - neměří tak aktuální strach a volatilitu, ale pouze tu očekávanou.
Obchodníci tak mohou využít práve onoho inverzního vztahu jako určité formy hedgingu, nebo spekulace. Ideálním nástrojem pak jsou futures kontrakty na VIX, které je možné obchodovat pomocí CFD, opcí nebo ETF fondů.

Practical demonstration: COVID’s rampaging the US markets (March 2020)

Let's look at an example from recent history. In March 2020, US stock indices experienced a significant correction following the outbreak of a coronavirus pandemic. Everything "peaked" on Monday 16 March, when even the S&P 500 index fell by almost 13%, while the VIX index set an all-time closing price record of over 80 points. The chart below shows a D1 chart of the VIX index, which has been rising quite significantly since February 22. Even with the later market timing, traders have had plenty of time to hedge against significant losses by buying CFDs or call options on the VIX.

VIX graph purple trading mt4
Chart 1: VIX Index in the MT4 platform on the D1 timeframe

Thanks to the S&P 500 futures contract, this famous US stock index can also be used in anticipation of a crisis. Traders can, therefore, trade CFDs, options or ETFs in a similar way to the VIX index. We have recently started to offer both instruments (S&P500 and VIX index) in the form of futures, so Purple Trading clients can use them for hedging in case the nervousness on the markets starts to grow. Check out the trading specifications of the S&P500 and VIX futures.

Hedging the market decline of the first half of 2022

We don't have to go very far for another significant decline in equity markets - the first half of 2022 was one of the worst on record for US equities, with the S&P 500 down more than 20%. The portfolios of many long-term investors took a big hit. However, this may not have been the case should we used an appropriate hedging. For example by shorting the S&P 500 index via CFDs. These can be used on most global equity indices, which are also part of Purple Trading's offering.

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Chart 2: S&P 500 Index in the MT4 platform on the D1 timeframe

Hedging with gold

In times of economic crisis, gold, or shares of gold mining companies, is a rather interesting instrument choice for hedging. Gold has long been known as a "safe haven" - an asset where investors move their funds in times of uncertainty. However, this does not mean that you should immediately buy gold bars. There are also a few drawbacks to gold, as it does not earn a regular return and its storage can put some investors off. It is also certainly not true that if an economic crisis starts, the price of gold will immediately rise. Like other assets, gold is affected by a number of factors and price of gold reacts to each crisis differently.

Practical demonstration: March 2020 again, but this time with gold

But let's look again at the situation in 2020, when the coronavirus has significantly shaken the stock markets. Gold also underwent a fairly significant correction in March, when its price fell from USD 1 700/tr. ounce to around USD 1 500/tr. ounce. However, gold quickly regained its second wind and by August had made new all-time highs, hitting the $2 100/tr. ounce mark. The S&P 500 stock index only managed to erase its losses over the same period, returning to similar levels as they were at the end of February. Thus, a well-timed purchase of options or CFDs on gold can significantly limit potential losses from investing in equities during a crisis.

Chart 3: Gold in the MT4 platform on the D1 timeframe

Analysts agree - another crisis may be around the corner

The economy works in cycles, so the arrival of a crisis is inevitable. The question, of course, is when it will happen and how severe the consequences will be. If you want to be prepared for the crisis and hedge your positions, you can find all the above mentioned instruments in Purple Trading's offer. We wish you successful trading!

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CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 76.60 % of retail investors lose their capital when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.