24/7 Wall St.

Investors almost always worry about a stock market crash, but when headwinds start to look stronger than the positive forces, they really start to worry that the rug can get yanked right out from under them. Perhaps what retail investors should do is try to learn what the professionals do with their clients’ money and their own money. Very few fund managers sell out of stocks entirely. After all, cash never rallies, and it is widely known that bull markets always seem to crawl a wall of worry.

24/7 Wall St. is identifying and discussing several strategies that investment managers, hedge funds and market gurus use to keep their toes in the stock market but manage to avoid major risk of a stock market crash. Performance and assets under management are everything to the hedge funds and institutional money managers, because their asset base and their performance are how they get paid. Now that the 2% management fee and 20% performance fee structure has been changing, these managers have to guard against too much risk leading to too high of losses.

Even after a summer pullback, the stock market performance of 2013 was better than most fund managers have seen in a decade or more. The last thing that a portfolio manager wants is to see a stock market crash rob them of their strong performance. Imagine trying to explain to clients how you wanted more upside even after stocks have more than doubled from the lows of 2009, even with all the warning signs that were evident in August of 2013.

24/7 Wall St. looked at five different strategies that many of the top hedge funds and institutional money managers may use to prevent a total wipeout of their performance. These strategies do not have any significant barriers to entry. Frankly, they can be used rather easily by any cautious investor.

These strategies include writing call options or buying put options, as well as shorting exchange traded funds (ETFs) and futures. We have of course discussed the method of gradually selling out of profitable positions rather than selling the whole boat, and there is the method of simply rotating into defensive shares. These are all discussed in detail, with examples for clarity.

Starting an exit, but not an exodus. Think about the feeling of having massive profits after years or months of gains. You never go broke taking a profit, but you can always keep some money on the table even as you lock in some gains. This makes sense to most people, except that the time to sell is at market highs rather than after a crash or after a big sell-off.

The most obvious trade is the classic “I doubled my money, now what?” strategy. This gives you the opportunity to sell half of your position, effectively taking your cost basis down to zero for the remaining position. The market gave you that money, so now you are playing with the house’s money. If the reason you wanted to own the stock back then has not changed, then this allows you to keep a toe in the water but not take the risk that all of that profit could disappear.

Sell calls, make more money. Writing a call option is a great way to start letting your stocks produce income, even if a stock pays no dividend. By selling call options, covered calls that is, fund managers are able to make income, and they are able to specify that they are willing to sell a stock if it reaches a certain price by a certain date.

As higher volatility comes into the stock market, it also means that most writers of options can collect higher premiums. If stocks simply fight it out for small gains but no losses, then the premium collected will continue to lower an investor’s cost basis. If General Electric Co. (NYSE: GE) is trading back down around $23 and the 52-week high is $24.95, selling a $25 call, say six months out, might bring in another 2% or 3% of income. For more volatile stocks like Apple Inc. (NASDAQ: AAPL) or Google Inc. (NASDAQ: GOOG), a strategy of selling out-of-the-money calls with similar upside strike prices likely would generate much higher premiums.

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Keep it simple, buy downside protection. Have you heard of KISS, as in “keep it simple stupid”? The easiest and most simple market protection that any investor can get is simply buying a put option that is only slightly out-of-the-money. The so-called put is a contract that gives a stock owner the right to sell the stock at a set price, even if that stock price falls 20%, 40%, 60% or worse. Spending money to buy this protection does of course increase your cost basis, but it will let even the most timid of investors sleep at night without a worry.

If you want to get slightly more sophisticated in puts and calls, there is a combination strategy of a costless collar. There are straddle and spread strategies as well, but creating a collar using this strategy can keep an investor’s cost basis the same or nearly the same. This is where a fund manager, or Joe Public, would sell a call option and use the premium collected from that sale to purchase the protective put option contracts. In this case, if the stock rises too much it is called away, and if it falls below the strike price then the shareholder puts that stock to them at the strike price.

Shorting futures or Spyders. If a fund manager’s stock or a group of stocks held in a portfolio is largely correlated to the broader stock market, it is possible to short-sell the S&P 500 futures or the SPDR S&P 500 (NYSE: SPY) while still holding the stock(s). It is likely a cheaper hedge than writing or buying individual stock options, but it effectively locks in gains or prevents losses if the markets go haywire. Frankly, this is how many fund managers can go on vacation and still sleep at night without much stock market risk.

The trick is knowing how much to risk to hedge against in a portfolio. In a large fund or portfolio, shorting futures or an ETF could be a large “short position” in actual dollars. This strategy unfortunately also removes the upside in the stock market as well if the market rallies rather than crashes. Many fund managers will use this strategy as a partial hedge with 25% or 50% of the entire portfolio if they want some protection but not to remove all the upside in case stocks scream higher.

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Going Defensive. Many fund managers want the upside of the stock market without the risk of the aggressive growth stocks. Some fund managers are required to keep a certain percentage of their assets in stocks, regardless of market conditions. When they start to get nervous they may decide to rotate out of riskier technology or biotech stocks and “hide out” in defensive stock sectors that are unlikely to suffer major losses out of the blue. The one catch in going defensive is that if the stock market is going to fall 10%, 15%, 20% or more in a short period, then defensive stocks likely will get taken to the woodshed as well because of the extreme move and panic. Generally and historically, defensive stocks fall much less than high-growth stocks, even in times of panic.

Going defensive usually involves rolling out of growth and shifting rapidly into utilities, big-cap pharmaceuticals and consumer staples giants. Buying shares of companies like Procter & Gamble Co. (NYSE: PG) and Clorox Co. (NYSE: CLX) is almost always less risky than taking a big position in Apple Inc. (NASDAQ: AAPL) and in Google Inc. (NASDAQ: GOOG).

Now that ETFs are more prevalent, a fund manager that needs to move a quick billion dollars into defense and out of riskier growth stocks can buy the Utilities Select Sector SPDR (NYSE: XLU), Health Care Select Sector SPDR (NYSE: XLV) or even the Consumer Staples Select Sector SPDR (NYSE: XLP) to take on a defensive portfolio posture.

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We have written about how hedge fund managers are using ETFs to accomplish their strategies and lower costs. We also have pointed out the growing risks in August that simply were not facing investors in July.

We did not bother giving the “sell it all” strategy because many investors who sell out of every stock and go into cash often create unwanted or unintended tax situations. Then there is that reminder again that cash never rallies and bull markets crawl up a wall of worry. The long and short of the matter is that there are many ways to limit stock market risk while still staying in the market, including how to prepare for a market crash.