Learning Center

In September 2011 the Swiss National Bank set the franc's minimum exchange rate at 1.20 per euro. In early January 2015 Swiss National Bank president Thomas Jordan reiterated that the peg was a "cornerstone" of the central bank's monetary policy. A short time later -- on January 15 to be precise -- the Swiss National Bank removed the peg, which sent the franc soaring as much as 30%. In the process, that move unleashed a world of financial hurt for traders/investors who levered up on the cornerstone of that peg.

This is all old news by now of course, but it serves as a sobering reminder that positions deemed to be inviolable can, and do, get violated, often in an abrupt manner and often at a great cost to those directly involved in the positions and, unfortunately, to those indirectly involved.

It doesn't have to be that way. Potential losses could be minimized, or even avoided, if one is hedged for the possibility of the inviolate position getting violated.

Burned By Complacency

When something seems like a sure thing, it is understandable that one might think it's simply wasting money paying for some form of insurance to guard against the thing that won't happen.

It's sort of like convincing yourself that you don't need car insurance because you've never had an accident or that you don't need home insurance because you've never had a fire. Paying the premiums every month is just throwing money out the window.

Certainly, for traders/investors who took the Swiss National Bank at its word and were lulled into complacency with a three-plus year cap on the franc, there was just no wrapping their mind around the thought that anything could go as wrong as it did.

For example, Everest Capital Global Fund, which had $830 million in assets at the end of 2014, lost almost all its money after the Swiss shocker, according to a Bloomberg report, since the fund was betting on a decline in the Swiss franc. Citigroup (C) and Deutsche Bank (DB) reportedly lost about $150 million each at the time.

An Aura About Them

We would hope that everyone learned an important lesson with the Swiss franc debacle. It showed once again how leverage, used to fire up big returns with little of one's capital at stake, can backfire in an even bigger, and quicker, way when a sure thing goes awry.

The life cycle of a sure thing can be longer in some instances than others or, conversely, it could be shorter in some instances than others.

One can never truly know. The prevailing aspect in both instances, though, is that there is heightened confidence in profiting from the position. Accordingly, there is less of an emphasis -- if there is any at all -- on protecting against downside risk.

The point is that one needs to take stock of how strongly they have embraced ideas with a sure-thing aura about them.

Are you hedged at all for an adverse turn in the conventional wisdom? Have you increased your position using borrowed money? Can you handle the losses that arise from selling that is forced and emotionally charged by others trying to stem the bleeding of their own leveraged trades? Have you accounted for any downside risk?

Between the Hedges

There are several approaches that can be used to hedge for downside risk (the same goes for upside risk with short positions, but for our sure-thing purposes here we'll keep the discussion limited to downside risk).

1. Simply take some money off the table.


2. Put options can be purchased to limit single-stock risk and index put options can be purchased to limit market risk.


3. Stop-loss (or sell-stop) orders can be placed, which order a sale to take place at the first available market price beyond the limit order.
   Note: Stop-loss orders work well in orderly markets, but don't necessarily pan out as intended in disorderly markets (which is what one often sees when sure-thing ideas are disproved) considering they are executed on the first available market price beyond the stop-loss order. Accordingly, a stock could gap down, and you could get filled at a market price well below your sell-stop order.


4. Stop-limit orders provide a price limit guarantee, but here, too, there is no guarantee they will get executed in a fast-moving market.
   Example: You place a stop-limit order at $47 for a stock trading at $50, but if it gaps down to $45 and the order doesn't get filled, it will remain unfilled until the stock gets back to $47.


5. Inverse exchange-traded funds (ETFs) can be purchased that act as an offset to a long position taken in a specific asset class.
   

   Examples for indexes:

   1. ProShares Short S&P 500 (SH)
   2. ProShares Short Russell 2000 (RWM)
   3. ProShares Short QQQ (PSQ)

   Examples for stock sectors:

   1. ProShares UltraShort Nasdaq Biotechnology (BIS)
   2. ProShares UltraShort Semiconductor (SSG)

   Examples for foreign markets:

   1. ProShares UltraShort FTSE China 50 (FXP)
   2. ProShares Short MSCI Emerging Markets (EUM)
   3. ProShares UltraShort Europe (EPV)

   Examples for bonds:

   1. ProShares Short High Yield (SJB)
   2. ProShares Short 20+ Year Treasury (TBF)

   Examples for commodities:

   1. United States Short Oil Fund (DNO)
   2. PowerShares DB Gold Short ETN (DGZ)

   Example for currencies:

   1. PowerShares DB US Dollar Index Bearish Fund (UDN)

Please note that the ETFs listed here are not specific recommendations. They are simply held out as examples to convey the point that there are opportunities in the ETF universe that can help mitigate losses in downside moves. Please be sure to research further to determine if these ETFs, or any others, fit with your risk tolerance and investment needs.