Whitney Tilson advocates that buying long-term put options (LEAPS) is the best way to hedge against a down market, and he is probably right.
Comparing to shorting stocks/indexes directly, buying long-term put options have limited downside but unlimited upside. I learned my lesson the hard way, I shorted AMZN back in May 2003 at #33, only to see the issue climbed higher day after day. The irony is, after I covered the short at $58 in October 2003 (With a substantial loss), the stock started to trend downward, now trading at $43 apiece today. (Whitney confessed he had the same terrible story when shorting some Chinese Internet portal sites.)
I'm considering to adopt the same strategy pretty soon so I checked out the QQQ and underlying option price today: QQQ is trading at $36.50 now, and the January 06 Put options are trading at:
Strike Price: Bid/Ask
$30: $2.10/$2.40
$31: $2.40/$2.70
$32: $2.70/$3.00
$33: $3.00/$3.40
$34: $3.40/$3.80
$35: $3.80/$4.20
$36: $4.20/$4.60
$37: $4.70/$5.10
$38: $5.10/$5.60
$39: $5.60/$6.10
$40: $6.20/$6.70
Take the example of $36 Jan 06 put, if I can buy the option at $4.40, it only takes Nasdaq to drop 13.5% in the next 23 months for me to break even. Buying $37 Jan 06 put at $4.90 will only require 12.1% drop to break even, though potential upside, on the proportion basis, will be a bit smaller compared to the $36 put.