He says it is essential to guard against today’s downside risks with trailing stops, inverse ETFs, and put options.

And every investor should have a plan to re-engage with the markets when this financial storm passes.

This from Money Morning:

As the worst financial crisis in recorded market history rocks Wall Street, millions of investors on Main Street keep asking a single question.

When will this end?

The market volatility is unprecedented: Where professional traders once ranked a day as “wild” if we witnessed a 300-point swing, in recent months we’ve seen 600- and 700-point swings on a regular basis. On Oct. 9, a Thursday, we rode out a record-setting swing of 1,000 points.

That wild backdrop is bad enough. At the same time, however, the major market indices are heading lower – at times with a speed and ferocity never before seen. But the real killer is that there is seemingly nowhere to hide.

This is what Wall Street’s Armani Army doesn’t tell you about traditional diversification: It doesn’t work when everything goes down at once. (The one exception is the specialized inverse investment vehicles that we’ve repeatedly counseled you to employ precisely to prevent this kind of total freefall. Two examples that we’ve mentioned numerous times were the Rydex Inverse S&P 500 Strategy Fund (MUTF:RYURX) and the ultra-aggressive “2X” ProShares UltraShort Financials (AMEX:SKF) exchange-traded funds).

Most noticeably, of course, was last Friday’s trading, which began after an overnight bloodbath in the markets overseas. A notice from the CME Group Inc. (CME) that stock index futures contracts were “limit down” – meaning they’d achieved their maximum allowable downward move for U.S. stocks even started trading for the day – didn’t help much.

While much of this is commonly explained away as a panic reaction to the news, the reality is that it’s primarily a financial panic that’s driving this market action lately. And, just in case you recall my comments a few weeks ago about not having seen the hair on fire selling I thought lay ahead, this is exactly what I was referring to.

This time around, ironically, it’s not panic from normally flighty retail investors that’s causing the markets to go haywire. Instead, it’s the big boys that are apparently panicking.

My experience suggests that one or more hedge funds have imploded. Whether by margin call or redemption proceedings is a moot point. We won’t know for sure until much later next week when the newspapers finally catch up, but the massive swings we saw in currencies, gold and other commodities are certainly consistent with an unprecedented liquidation – and a forced one at that. Perhaps even more than one.

Long the domain of hedge funds and their uber rich clientele, many hedge funds were over-weighted in these categories in recent months in an attempt to chase performance. Overweighting, in case you’re not familiar with the term, means they’ve made excess investments in those areas. And chasing performance means they’re trying to create higher returns by making disproportionately larger bets than they would otherwise. Part of this could be from simply trying to generate larger performance fees, but it could just as easily be attributed to anxious managers placing ever-larger bets in an attempt to make up losses (most hedge funds are under water this year).

Where this gets fund managers in trouble is when they make these over-weighted bets by using leverage. You’ve probably heard this term a lot lately. In case you don’t understand what it really means, let me digress for a moment to explain it. Leveraging up (or simply “levering” to those in the industry) means using borrowed money to control a huge pile of assets that you wouldn’t otherwise be able to control.

In recent years, for instance, it wasn’t unusual for a hedge fund to lever up 30 to 1, meaning for every $1 dollar they invested they borrowed $29. As a result, a fund with $100 million under management could control $300 million or more of investable assets. I’ve heard of some funds running 50 to 1, while currency traders routinely run 100 to 1.

While using other people’s money dramatically enhances the potential for higher returns, it really enhances the potential for massive losses. Where this gets them into trouble is that a fund running 30 to 1 only has to lose 3% of the $30 worth of equity to get wiped out, as in kaput.

Somewhere along the way, as bad turns to worse and performance deteriorates, a hedge fund’s creditors will place a margin call, meaning they want the hedge fund to pony up more collateral or return the money it was loaned. Or, investors will place redemption requests meaning they want out. Either way, this forces the operator of a hedge fund to raise money any way it can.

If a given hedge fund does not have enough cash to meet the margin calls or redemption requests, they have to raise cash by selling assets. And they typically start with the most liquid stuff like gold, currencies and commodities. At first, the sales progression will be orderly, but as I suspect was the case last Friday (and on many big down days recently where chaos ruled), it will rapidly deteriorate into a fire sale where the hedge funds involved dump everything they can at any price just to get out.

And that’s where their problems affect you and me.

As scores of highly leveraged hedge funds dump billions of dollars worth of holdings at once, they effectively “flood” the markets with whatever the asset is that they are trying to sell. In doing so, they push the values down for the rest of us.

For an example, imagine a house in your neighborhood selling for 50% of its appraised value. Upon completion of the sale, all “comparables” in the area, including your own home, will likely take a hit as a result. So it’s in everybody’s interest to keep prices as high as possible.

But nobody can do that when there are more homes than buyers – even in the best neighborhoods.
So when is it going to stop?

We don’t know. No one does. Hedge funds are notoriously secretive in their reporting, so even though there are estimates as to how much they own and (by implication) how much they owe, it’s hard to gain perspective on how much leverage is actually being used. Nor do we really know who holds what asset – especially as it relates to potential liquidations.

Over the weekend, rumors were flying that U.S. Federal Reserve examiners are hounding Citadel Investment Group LLC regarding “counterparty risk” and its exposure to debt. Citadel, naturally, vehemently denies this, but lately where there’s smoke, there’s certainly been the potential for fire.

[...] The bottom line is this: What should we do for now?

That’s actually the easy part even though it may not feel like it.

1. If you’re retired, take a good hard look at how much money you really need for the next five to 10 years. Talk to your financial advisor and, if needed, take some risk off the table. Move what you need into cash, or such safety-first choices like the American Century Capital Preservation Fund (MUTF:CPFXX). Do not own anything you would not want to have in your portfolio if the stock markets were to be shut down for a short time.

2. If you’re not retired – but are close – and have properly diversified your money to something akin to the 50-40-10 structure we advocate (50% base-builders, 40% global growth and income, 10% speculative), hang in there. And remember, this is exactly why we diversified our holdings in the first place – to get through the rough spots. It’s just that this is perhaps the roughest most of us have ever seen.

3. Stick to your plan. Hopefully that includes the disciplined use of trailing stops to capture gains and minimize losses, as well as specialized inverse holdings that profit with each further decline. And don’t forget options to hedge existing risks.

4. Above all else, make sure you have a plan – as we do – for re-engaging the markets when the coast is all clear. It may be awhile before we reach that point, but it’s important to maintain your upside potential in a down market. When the train leaves the station, the one place you don’t want to be is left behind on the platform. Studies like those from Standard & Poor’s show that investors can typically make up 80% or more of bear market losses within the first year of a recovery, once that recovery actually arrives.

Source: Four Ways to Sidestep the Damage Wall Street’s Big Money Movers are Inflicting on Main Street

More from The Smart Profits Report:

“The market is very worried about a severe international economic downturn.” That’s the verdict of commodity strategist David Moore at the Commonwealth Bank of Australia.

He was speaking the day after the Dow endured its second-worst one-day slump in history (733 points), with stocks losing a staggering $1.1 trillion in value. The index has recorded triple-digit movement on 20 of the past 23 days and posted just one positive day this month. The Associated Press says investors have lost $8.3 trillion from 401(k) plans, pension funds, college savings accounts, and other investments.

Sure, September’s consumer price inflation reading came in flat, compared with August. But it doesn’t disguise the fact that U.S. employers are shedding jobs en masse, while retail sales dropped 1.2% in September. On the bright side, though, this has led to oil prices dropping by more than 50% since July’s $147 record high. The black goo currently trades at a 14-month low around $70 a barrel amid speculation that consumption will drop as consumers cut back and a global economic recession takes hold.

While there’s nothing you or I can do about a recession, there are steps we can take to combat the stock market’s nosedive. Let me take you back to my colleague Marc Lichtenfeld’s “Five-Point Bear Plan” that he published here back in August 2007. What was true then is even truer today…

Your Five-Point Bear Plan

1. Sell Short: This is when you sell a stock before you own it and buy it back later. The premise is that you expect to sell high and buy low, in that order. But you need to borrow shares first in order to be able to sell them. And of course, the risk is that a stock can go infinitely higher. Your broker must also approve you before you can sell short.
2. Buy Put Options: You can buy put options on a stock or index that you expect to decline. This gives you the right to sell the asset to the seller of the option at a specific price in a pre-specified time. To do so, you must buy a certain number of options contracts – with 100 underlying shares equivalent to one contract. For example, if you think that American Express (NYSE: AXP) is going to decline, you can buy the November $20 puts. This gives you the right to sell the stock at $20 anytime before the third Friday in November, no matter where the stock is trading. If the stock heads lower, your put options should increase in value. Conversely, if the stock is trading above $20, your put expires worthless.
3. Sell Call Options: If you own shares that you don’t want to sell, but think the price may fall, you can sell call options against them. This gives the buyer the right to “call away” your shares at a specific price. Let’s say you own shares of Apple (Nasdaq: AAPL). You can sell the January $90 calls for $19, meaning the buyer has the right to buy your shares for $90 any time before the third Friday in January. No matter if AAPL is trading at $100 at that time, you’ll still be forced to sell at $90. However, if the stock is below $90, the option expires worthless and you keep the $19. You must be approved to trade options if you want to do this.
4. Bear Mutual Funds: There are several mutual funds that seek to profit when markets go down. They include the Prudent Bear Fund (BEARX), ProFunds Bear (BRPIX) and Rydex Inverse S&P 500 Strategy (RYURX). Be sure to read their prospectuses and holdings carefully before you take a position. You’ll also be required to invest a minimum amount and pay annual maintenance fees.
5. Bear ETFs: If you don’t want to short stocks or indexes, don’t have approval to trade options, or don’t want to pay the higher fees associated with funds, you can buy ETFs (Exchange-Traded Funds) that short various indexes instead. For example, the Short QQQ ProShares (AMEX: PSQ) seeks returns that correspond to the inverse of the Nasdaq 100. In other words, if the Nasdaq 100 declines 10%, PSQ should be up roughly 10%. There are also various bear ETFs, including sector specific and leveraged funds such as the UltraShort Oil & Gas ProShares (AMEX: DUG). This fund seeks returns that equal twice the inverse performance of the Dow Jones Oil and Gas Index.

(Please note: The companies/funds mentioned above are not actual recommendations, just examples).

Buff Up In A Rough Market

The bottom line here is that you shouldn’t just run off with the crowd and sell off, because that’s what they’re doing. Take a page out of Warren Buffett’s book instead.

Granted, the guy can afford to lose a few dollars here and there, but his investment philosophy is the important thing: He doesn’t cave into uncertainty, fear, or panic. He just rides out the market’s fluctuations and, in fact, rather than selling off, he uses downtimes as an opportunity to accumulate his positions for a discount.

And that’s what has helped make him one of the world’s most successful investors.

By coincidence, Marc just e-mailed me the first part of his next Xcelerated Profits Report article, which ties into this perfectly. He says:

“Market slides like the one we’re experiencing give us an opportunity to get into great stocks at prices we could only have dreamed of just a few weeks earlier. Yes, it’s tough to buy while everyone is selling, but history shows us the most money is made by buying into a panic.

“I’m not suggesting we just blindly throw our money at the market. But the selloff is providing us with an opportunity to get involved with biotech – and I can’t think of a sector I’d rather be in than biotech right now. No matter what the economy has in store for us, people are going to continue to take the medicines that fight their illnesses. And this month, I’ve got two recommendations that have me salivating…”

Out of fairness to our paying subscribers, I can’t reveal those picks to you here. But if you act fast, you can get yourself on our list in time to receive them in the upcoming issue. It costs just $49.50 for a 12-month subscription and each issue is guaranteed to contain not only specific recommendations, but also the sophisticated, professional strategies that will elevate you above the crowd and allow you to make more money more safely and in a faster time. Check it out here.

Source: You Can Profit In A Miserable Market Like This – Here’s How…

And history shows that such periods can be the worst for investors to navigate – especially when they follow a record stock-market run, such as the all-time-highs that U.S. share prices reached last fall.

In the United States, for instance, Dow Jones Industrial Average hit 381 on Sept. 3, 1929, a record pinnacle achieved in advance of both the Great Crash and the Great Depression that followed – and a level that wouldn’t be eclipsed again until November 1954 – more than 25 years later.

From the Great Crash, fast-forward 60 years, to 1989 Japan. On Dec. 29 of that year, the Nikkei 225 Index topped out at 38,957.44, before closing at 38,915.87. By the following September, stock prices had nearly been halved – and there was still much more bloodletting to go. (Despite several subsequent rallies up over the 20,000 threshold, the Nikkei ultimately bottomed at 7,830 in April 2003. It closed yesterday – Thursday – at 12,887.95, still down 67% from its trading high 19 years ago).

The fallout from Japan’s slow motion, stock-and-real-estate-market meltdowns was incredible. By early 2004, Japanese houses were selling at 1/10th their peak value, and commercial real estate was selling for less than 1/100th of its record highs. All told, an estimated $20 trillion in stock and real estate wealth was vaporized (although one could easily argue that the peak values weren’t real to start with).

That’s scary stuff, especially because many experts fear the U.S. version of the Lost Decade that’s to follow could be much worse. After all, the U.S. financial crisis is much, much bigger, and the resultant malaise is arguably going to take much longer to work through.

Let’s look at some of the some of the profit plays that will allow investors to sidestep a long U.S. slumber – and profit just the same.

1. Miss the Market Meltdown: The Dow closed at an all-time record high of 14,164.53 on Oct. 9 of last year. With yesterday’s 207-point rally, the Dow closed at 11,446.66 – leaving the 30-stock blue-chip index down 19% from the October record, leaving it right on the doorstep of a bear market.

But what if things were to get much worse? For the Dow to match the Nikkei’s wrenching decline of 67%, it would have to drop all the way down to 4,574.29 – an area it hasn’t seen since the first half of the 1990s.

Will the Dow drop that much? Probably not.

But it doesn’t hurt to hedge. That brings me to a key point: There’s a big difference between “diversification,” which most individual investors equate with “protection,” and actual “hedging,” which is part of an investment-protection package that professional traders employ. If we believe a market poised for a real fall, we want to hedge and find an investment that’s going to go up in value while everything else is going down.

For us, that investment is the Rydex Inverse S&P 500 Strategy Fund (RYURX). RYDEX URSA is a so-called “inverse fund” that’s designed to profit as the Standard & Poor’s 500 Index declines in value. In that way, it complements our other holdings by providing some portfolio stability.

As Money Morning Investment Director Keith Fitz-Gerald says, hedging is such a compelling strategy because financial studies demonstrate that “even though broad sections of the markets may decline over time and our portfolios with it, we need only have a small section permanently hedged at any given time. The reason is that, by having a small portion of our assets (5%-10% or less) earning above-average returns, our overall returns are far higher over time.”

2. Gold Isn’t Just for Hedging Anymore: Mention the word “stagflation” to anyone who worked and invested during the 1970s, and I’ll bet you’ll actually see that person physically shudder at the memory. Stagflation – the double-whammy combination of stagnant economic growth and high inflation – was thought to be an impossibility, until it showed up during that decade, leaving ruin in its wake.

But for our purposes, no matter whether we’re looking at stagflation or inflation, one thing is clear – we’re looking at higher prices. And when prices are on the upswing, gold is the one investment you certainly want to own.

Then there’s also the whole “Lost Decade” outlook for the U.S. economy. In a misguided attempt to slowly deflate the asset bubbles it created with a years of overly expansive monetary policies, the U.S. Federal Reserve is now keeping interest rates at artificially low levels – gambling it will still be able to launch a successful counterattack on inflation later on. What’s more, the central bank also has made the ill-fated decision to diversify into the “bailout business” with its intervention in the Bear Stearns Cos. (BSC) and Fannie Mae (FNM) and Freddie Mac (FRE) debacles.

The artificially low interest rates will continue to punish the U.S. greenback, sending it lower and causing inflation to accelerate. And the trillions in debt the U.S. government’s balance sheet will take on from the Fannie and Freddie bailouts certainly won’t help.

In addition to the bleak-sounding inflation-case for gold, there’s also what I like to call the “wealth case” for the “yellow metal.” As the consumer classes in China, India, Latin America and Emerging Europe grow in both breadth and depth, their ability to buy luxury goods will finally intersect with their desire. And gold will be a major beneficiary.

But how best to play it? There are mining companies, bullion, coins and even jewelry. Everybody has his or her preferences for gold investments, including us. We prefer the SPDR Gold Trust Exchange Traded Fund (GLD). There’s no delivery risk, it’s liquid, and you can buy and sell easily through any online brokerage.