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.
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.