You now have removed all the market risk from your portfolio of stocks. If the market moves lower, as you believed, you will make money on the ETF to make up for losses in your stocks. Of course, if you are wrong and the market moves higher, you will lose money on the ETF that will offset the gains in your stocks.

Another option, and probably a more prudent option, would be to partially hedge your portfolio by purchasing a smaller amount of the inverse ETF.

The purpose of hedging is to be comfortable with your market risk but continue receiving dividends and not incur the taxes and commissions due to selling and buying your individual stocks.

One of the benefits of using the inverse ETF as a hedge is that your risk is defined and limited. Keep in mind an investor who shorts the market outright would, in theory, have undefined and unlimited risk. The risk of an inverse ETF is the amount you have invested.

Using Inverse ETFs as a hedge can be a potent diversification strategy to reduce asset correlation and investment risk.

It is also a strategy that requires careful application, monitoring, and frequent rebalancing. Used properly, inverse ETFs can be a valuable tool to hedge portfolio risk.

The following post was republished with permission from Arbor Investment Planner. 

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