On Shaky Ground

The market’s euphoria seems to be wearing off. Maybe higher oil prices have to do with it, or it could be the slowdown in China, or unrest in the Middle East or bad numbers on the job front. It really doesn’t matter which reason you choose. Markets correct and that is a fact. Monday morning quarterbacking might be a good exercise in verbal discourse, but looking at your portfolio after the fact provides little solace.

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At times like this you have to be proactive. It’s hard, I know. With markets near 52-week highs the gut instinct is to buy and buy more in case you miss the boat. Well, let me tell you the boat left the dock two years ago and now it might be time to make a stop at a port. Except this port is not as pretty as you might expect.

It’s quite natural after a near 100% run-up from the lows to have a significant correction, something in the order of 20%. That it already hasn’t happened is an anomaly in itself. This bull-market is two years old now and that makes it one of the longest on record without a correction. The easy money has been made my friends and it’s time to put into place some protective measures. After all as the saying goes “it’s return of capital that is more important than return on capital”.

So, what are you doing today to protect your gains? It would be absurd to sell everything unless you are planning to retire tomorrow – and even then you are not going to need all of your money at once. Prudence dictates that you take the following measures:

1)    Set protective stops on your positions. This means that you put in place a disciplined sell strategy in ADVANCE of a correction. For example, let’s say that your maximum pain threshold is 10%. On each of your positions you enter a STOP-LOSS with your broker at a level 10% below the current share price. It’s really that simple. And if you get stopped out, don’t feel bad. Markets always provide new opportunities to profit and often times you can buy back the same position you sold at a nice discount.

2)    Buy protection in the form of PUT options. Put options give you the right to sell a stock or an index at a particular price. So, as the stock or index goes below that the price (called a strike price) your put option will gain in value offsetting the loss in value of your underlying holdings. This strategy is called a Married Put. For example let’s say you own shares in GE, currently trading at $21. If you were to buy let’s say a GE $21 put option that expires in June, you might pay $1 per share. If GE were to fall to $17, your stock would lose $4 per share but your put option would be worth $4 per share meaning your actual loss is only $1 per share (the price of the put option at expiration minus the initial cost of the put option).

3)    Buy a pure hedge. This means you just buy put options or go short the market in general. The best vehicle for this is the put option on the S&P 500 or (SPY-NYSE). You would have to buy a percentage that is in proportion to the shares that you own.

4)    Buy a “short” fund that trades in inverse correlation to the market. There are many ETFs out there that can offer you protection. However, be aware, these ETFs reset daily and do not provide cumulative protection. So you may gain one day just to give it all back or more the next. In order to trade these successfully there must be a sustained move in the direction you choose.

5)    Do nothing and ride the market down and then back up. Just be sure you don’t panic and sell at the lows, which is what most people do.

In a down market, if we get one, nothing is safe. Not gold stocks, not oil stocks and not even emerging markets or foreign market shares. The last correction revealed that correlation theory which says that some markets are correlated and others aren’t, really did not work well. During panics, people sell and they sell whatever they can. The markets become illiquid very quickly and it doesn’t take more than a few days of sustained selling to magnify losses. But, these losses are on paper and subject to illiquid real time markets and not a true reflection of long-term values as many people learned the hard way. Put yourself in a position to benefit from a downturn by raising some cash at these higher levels. There is no better revenge in a market crash or correction than being able to buy on the cheap!

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