How to beat the September blues

September got off to a bad start for investors. Weakness in the Chinese market and general concerns over the sustainability of economic recovery rattled investors early this week. The FTSE 100 shed nearly 2% on Tuesday to end the first trading day of the month down at 4,820.

Investors probably shouldn't be surprised. "It is hard to believe that a single month can disappoint investors so often, but September fits the bill," says David Schwartz in the FT. It's even worse when there's been a run-up of the sort we've seen since March. According to Schwartz, there were eight bull market years in recent decades when British shares gained at least 9% in the six months to the end of August. "Prices continued to rise in September just once" even then the gain was less than 1%. With this September looking at least as wobbly as history suggests, what can investors do to protect themselves?

Hedging your bets

You could of course just sell out of stocks. And if you were smart with your timing, and managed to join the 'dash for trash' that has seen banking and housebuilding stocks (among others) rocket over the past six months or so, then now is probably a good time to be thinking about taking some money off the table. These stocks might have further to run, but by the same token, they are also likely to be among the worst hit if the traditional September correction turns out to be something worse. Your profits and the risk involved in holding for longer should offset any trading costs.

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But if you're more of a long-term investor, and have been stocking up on the large-cap, high-yielding stocks we've been recommending as a core holding in recent months, then you probably don't want to sell out of the market. For one thing, defensive stocks have underperformed in the rally, so there's much less to lose in terms of gains. In fact, defensives may even rise as investors shift from cyclical stocks to 'safe havens'. For another, if you bought the stock based on getting a nice dividend yield, there's little point in selling and missing out on that. So how can you take out insurance against a falling market without selling out of it entirely? Here are a few options.

1. Buy put options

One way to protect your portfolio is to buy put options. These give you the right but not the obligation to sell an agreed number of shares at a specified level (the 'strike' price) to the 'writer' of the option, up to a set future date (expiry). The option writer collects a one-off fee ('premium') for selling you the right to sell your shares at the strike price. So you are betting the share price will fall, while the writer reckons it will rise. If the share price does fall, the value of your option will go up, as it gives you the right to sell at the higher price. The higher the strike price compared with the actual price, the greater premium you'll have to pay, because you're buying more insurance against a fall.

If you deal in 'exchange-traded' options listed in the FT under 'equity options' in the 'markets' section you can sell your puts at any pre-expiry point. For example, with GlaxoSmithKline (LSE: GSK) shares at 1,196p, the '1,200p strike' puts expiring on 20 November 2009 currently cost 63.5p each. But this contains a 'time value' based on the time left until expiry. If GlaxoSmithKline doesn't drop until just before the option expires, this 'time value' will fall, meaning the put price won't rise as much as the share falls.

2. Bet on rising volatility

The Chicago Board Options Exchange Volatility Index, or 'Vix', is known as Wall Street's 'fear gauge'. That's because it tracks the premiums paid for options tied to the price of stocks on the S&P 500. To put that simply, it measures the price of insuring against sudden market movements. If traders are worried about prices falling (which is usually what they're fretting about, rather than the other way around), then they'll be willing to pay more for an option that will let them cover their positions.

The long-term average on the Vix is around 21. In the wake of the Lehman Brothers collapse, it spiked as high as 81. It's currently trading at around 29. If the market does go into another slide, it's a pretty reasonable bet that it will end up far higher. The easiest way for retail investors to get exposure to the Vix is via the iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX), with an annual management fee of 0.89%. Be aware that it's denominated in dollars, so as a sterling investor you do have currency risk.

3. Spreadbet

You can hedge your exposure to falling share prices using spreadbetting. Say you hold 1,000 shares in Vodafone, currently trading at around 130p. If you want to hold onto them, and perhaps profit from any falls in the meantime, you can place a bet that the share price will fall. If it does, what money you lose (on paper) on your holding in the stock will be cancelled out by the spreadbet paying out a similar sum.

In this case, you'd go to a spreadbetting provider and sell Vodafone at 130p at £10 a point. It then falls to 120p, giving you a profit of £100 (£10 times ten 'points'), offsetting the £100 loss you'll have suffered on your Vodafone shares. If the price rises instead, to 140p, you'd owe the spreadbetting firm £100 but your shares will have risen by roughly the same amount too. Do remember, of course, that you will be charged a bid-to-offer spread (the gap between the sell and buy price offered by the spreadbetting provider), which will eat up some of your profits. However, this shouldn't be too onerous if you're betting on blue chips.

You can compare leading spread betting accounts here.