If there's one lesson to be learned from this year's market, it's this: Be prepared for a visit from Mr. Volatility. Recently Greece, and now Italy, have shelled domestic investors with V-bombs, making rubble out of many portfolios. With Portugal threatening more of the same, you're right to wonder about the origin of the next salvo.

Sudden and dramatic downdrafts have punctuated the generally bullish trajectory of the domestic equity market since the Great Meltdown. After a stutter-step in the summer of 2010, the Standard & Poor's 500 (SPX) managed to successfully retrace half of its 2007 to 2009 swoon. At one point in early May 2011, in fact, the SPX had made up three-quarters of the meltdown only to be battered from beyond The Pond. Debt-related drawdowns forced a test of critical support at the 1,125 level over the summer and early fall, sparking worries of a recessionary collapse. (See Chart 1.)

The prospect of contagion has got investors and advisors thinking more and more about hedging tactics. Nowadays, hedge options — literally and figuratively — are manifold. So, what is the most efficient way to maintain exposure to stocks' upside and safeguard against outsized volatility?

Building a Hedge

The first step in devising a hedge is sizing. Just how much hedge protection is actually required? At its essence, this is the same question you'd ask when buying insurance on other assets such as your car or home. How much self-insurance or deductible can you afford?

Suppose you invested in a domestic stock portfolio when the Standard & Poor's 500 (SPX) was at the 1,300 level. Let's say you're comfortable sustaining a short-term setback of ten percent and know your portfolio's beta is 1.20. Nominally, your loss threshold would then correspond to an SPX reading of about 1,192, or 1,300 × [1 - (10% ÷ 1.20)]. You'd want a hedge in place to safeguard against excursions below this level.

The next issue is timing the hedge. Forecasting the future can be more than a little tricky, but there are clearly times when the risk of a drawdown increases. Sell-offs can be telegraphed by chart patterns, such as head-and-shoulders formations and double tops, or by bearish crossovers of oscillators such as the MACD indicator. Often, these patterns can even predict the eventual depth of the sell-off.

Obviously, consistent fundamentals lend credence to technical signals. The congruence of sentiment gauges such as index put/call ratios, for example, can bolster the outlook. This ratio's a contrary indicator, so a precipitous decline in its numeric value — in other words, a dramatic increase in call open interest vs. that of puts — presages a market decline.

Finally, there's the choice of a hedging vehicle. It's important to remember that hedging carries a cost, so its economic sense is predicated on the size of its potential benefit. Simply translated, that means the more leverage, the better.

A short stock index futures position offers both leverage and simplicity, but may not be accessible to many investors. A hedge can, instead, be constructed with exchange traded funds but leads the investor to the question of which approach to take — the purchase of an inverse index fund or the short sale of a long-only product. For various reasons, these may not actually be equivalent positions. Take a look at the performance of SPX-based ETFs in the summer of 2011 as an example.

By the third week of July, the SPX had stair-stepped up to the 1,345 level on talk of increasing European Union aid to Greece and an overhaul of the EU bailout fund. At the same time, though, the put/call ratio for the ProShares UltraShort S&P 500 ETF (SDS), a leveraged inverse fund, was reaching new lows. The SPX deteriorated over the next two weeks, leading into the worst single-day sell-off since the 2009 meltdown. In a fortnight, the blue chip benchmark lost nearly 13 percent as the CBOE Volatility Index (VIX), the so-called “fear index,” doubled (VIX meters the average volatility assumption priced into options on the SPX).

S&P 500 ETFs

So, what if you were prescient enough to call for a hedge on your domestic stock portfolio in advance of the sell-off? What would have been your best protective move?

Some investors, naturally, have more choices available. For margin-authorized accounts, the merits of shorting a long-only index fund must be weighed against those of purchasing an inverse product. Then there's the leverage issue. Is it better to double- (or even triple-) down with a levered product or keep to a 1x exposure?

Long, unlevered exposure to SPX can be obtained through the SPDR Depository Receipts Trust (SPY) while the ProShares fund family offers the most liquid inverse and levered products. SH, the ProShares Short S&P 500 ETF, is the single-shot inverse product, designed to deliver -100 percent of SPX's daily return. Its big brother is the ProShares UltraShort S&P 500 ETF (SDS) mentioned above, which aims for -200 percent of SPX's day-to-day gains or losses. Levered (that is, 200 percent) exposure to the SPX daily return is the mandate of the ProShares Ultra S&P 500 ETF (SSO).

Chart 2 and Table 1 compare the performance of the SPX-based products over the two-week sell-off in the summer of 2011. Each position illustrated was margined at the Reg T (50 percent) equity requirement, meaning cash deposits were necessary. You can see that a compounding effect inured to the benefit of ProShares owners — long inverse funds, levered or not, trumped the hedge protection of long-only product short sales. Cash deposits can represent substantial front-end costs for ETF hedges. Clearly, ETF hedges ain't cheap.

Options: “Cheap” Insurance

The option marketplace affords investors access to a variety of hedging strategies requiring little, if any, cash commitment. Protective puts, for example, can be purchased to fix a “worst-case” sale price. Keeping in mind your willingness to self-insure a ten percent loss, you could buy puts with an exercise price ten percent below the current market price (“out of the money”).

On July 21, SPX was trading at 1,343.80 while the SPY fund was offered at $134.49. A September $121 put — a contract guaranteeing an SPY sale about 10 percent under the current market — was then at just 25 cents a share, or $25 per contract.

Hedge protection can be obtained even cheaper by financing the puts with the sale of out-of-the-money calls. A September call, struck ten percent above the market at $148, could be sold for 38 cents a share. The call sale not only finances the put purchase, it leaves you with a 13 cent cash credit.

Writing the calls, of course, obligates you to sell SPY shares for $148 if the options are exercised by the buyer. But there's upside risk and a limit to potential profits in the trade.

As it turned out, there was hardly any upside to worry about. A dramatic spike in volatility accompanied the mid-year sell-off and grossly inflated put premiums. Within three weeks, SPY's price slid from $134.49 to $112.26 pumping up the September 121 puts 49-fold to $12.48. Chart 3 illustrates the price trajectory for the puts, the calls and the combined “collar” over the summer drawdown.

There's plainly more bang for the buck in options, but it's a marketplace reserved for investors with more sophisticated analytic skills and clearly articulated risk tolerances.

Fighting Volatility with Volatility

For years investors have followed the VIX as a benchmark of market fear. VIX is derived from the real-time prices of options on the SPX and reflects investors' consensus view of future (30-day) stock market volatility.

Option sellers build in their expectations of market volatility when they price their contracts so, all other things held equal, premiums tend to inflate when volatility is expected to increase; options tend to cheapen when there's a volatility downturn anticipated.

S&P Volatility futures and the exchange-traded notes that track them can be used to hedge against the downside “tail risk” associated with holding stocks.

If a volatility spike is expected in the immediate near-term, a naked long position in the iPath S&P 500 VIX Short-Term Futures ETN (VXX) would be the best bet. Here's why: Our summertime stock swoon was shadowed by dramatic inflation in the VIX, which jumped from 17.56 to as high as 48.00. VXX tracks the return from daily rolls of first- to second-month VIX futures, resulting in a constant one-month maturity. The VXX note's value ballooned 49.71 percent, more than matching the contemporaneous loss sustained by the SPX. In a margin account, the VXX note's gain was levered 8-to-1 compared to the SPX loss. Very futures-like, that.

Chart 4 illustrates the rate at which the VXX note gained ground when margined at Reg T. Of course, as with any exchange-traded fund or note investment, there's a cash commitment to consider.

So, What's the Best Hedge?

If simple is better, then the unlevered 49.71 percent return earned by a long position in the VXX note would have been your best bet this summer, followed by the 27.13 percent gain obtained through outright ownership of the double-short SDS fund. A 100-share position in either would have required a capital commitment of about $2,000.

The most dramatic hedge-side gain, however, would have been garnered by the option collar. Initiated at a net credit, the position required a negligible capital commitment and produced the most highly levered gains. A collar isn't the simplest of hedges, but it has proved to be the most capital efficient tactic examined here.

That doesn't mean that collars are always the best hedge bet. But there'll be time enough to see how other tactics work. At the rate things are going, we're likely to have plenty of opportunities to wrestle with Mr. Volatility in the months to come.