Not that it wasn’t always in the back of our minds, but Wednesday’s big plunge from the market caught too many investors off guard.
On Tuesday, we were talking about the S&P 500 being within striking distance of an all-time high. But by the next day, stocks dipped into the red ink, to the tune of more than 1%.
Could that one nasty day be the beginning of a correction that pundits have been calling for?
Nobody has a crystal ball, but after the 15% rally we’ve enjoyed since the November bottom, it might not be a bad idea to start planning for the possibility. Now’s the time to start mapping out a defensive plan that will help you survive — and perhaps even capitalize on — a major selloff.
In order from easiest to most aggressive, here are four tactics you should employ if you think things could go from bad to worse in the foreseeable future.
Sell (Some) Stocks
It might be a low-brow, unsophisticated idea, which is likely why so many traders don’t bother doing it. But sometimes, the smartest way of sidestepping a major pullback is simply by not being in it.
That’s not to say you should sell every stock you own. But if you were mulling taking profits on some of your more vulnerable names anyway, why not step out of them when and how you want, rather than being forced out later?
The catch: Timing re-entry into the market can be tricky.
While a falling market tends to pull down most stocks with it, a stock-market correction doesn’t necessarily drag down non-equity arenas. Take gold or bonds, for instance. Both the SPDR Gold Shares (NYSE:GLD) and the iShares Barclays 20 Year Treasury Bond ETF (NYSE:TLT) can and have moved independently of — even inversely to — the stock market.
The catch: Just because it’s a different kind of investment vehicle doesn’t mean it can’t or won’t fall at the same time the equity market does — they’re just not necessarily correlated.
Conventional mutual funds and ETFs go up with the market, and down with the market. Inverse funds, however, rise in value as the market loses ground. Clearly they aren’t long-term holdings, since stocks always move higher over the long haul. But, with the average bull market correction being greater than 8% (and frequently more than 10%), that’s enough gravy to make it worth a shot, even only as a hedge.
The ProShares Short S&P 500 Fund (NYSE:SH) is one of the most popular inverse ETFs; for every percentage point the S&P 500 loses, this fund advances by a percentage point.
There are even sector-based inverse ETFs if you believe a certain industry is particularly vulnerable.
The catch: As is the case with getting out of the stock market, timing the exit of an inverse fund trade can be tricky. It’s easy to justify sticking with these funds for too long, saying “we’ve not quite hit the bottom yet,” when in fact you have seen the bottom in the rear-view mirror.
These are in the same vein as an inverse ETF or inverse fund, but less of a commitment. A put is a bet — or contract — that a particular index or stock will lose value over the course of a defined period of time. As such, if that stock or index ends up losing value as predicted, that contract increases in value and can be sold at a profit.
The upside of an option is that it’s exactly that … an option, not a commitment. With a put option, the worst-case scenario is that the prediction is wrong, and the contract doesn’t gain in value. Despite the lack of a fruitful trade, options can be remarkably cheap. Indeed, some are cheap enough that if they do expire unsold or unexercised, it’s not a significant problem for the investor.
The catch: Though not nearly as complicated as some would believe, options can only be bought within an options-approved account, which requires a certain net worth and trading experience.
None of these strategies are complex or out of reach for most traders. The options-trading account might be a hurdle for some investors searching for a way to hedge their portfolio against a market pullback, but even that’s not very tough to climb over.
Perhaps the biggest challenge is convincing yourself that action is merited, then actually taking that action.
It’s comfortable to maintain the status quo and just ride out a market correction. But that’s not always the right thing to do for your portfolio.
As of this writing, James Brumley did not hold a position in any of the aforementioned securities.