Did I just hear right? Did you say you don’t have a crash protection protocol in place? You’re all set for the zombie apocalypse but not for a major correction or market crash? That has to change, and I’m here to help.
There are a few schools of thought on what to do in a market crash. For those who buy stocks with the intent of holding them for a long time, some say to do nothing, have cash to buy a few bargains and sit tight during the market crash. That’s not a bad strategy if you have at least five years before you plan to exit stocks.
Trading “gurus” say you should sell everything in a market crash and wait to buy back in. That’s terrible advice because you’ll likely panic and sell at the bottom of the market crash.
I have better ideas.
The first defense against a market crash is to have a long-term diversified portfolio. During the financial crisis, my diversified portfolio suffered a 35% drop … but the market fell 55%. That alone should give you an idea of why diversification is so important.
Another approach is to short the market as the correction is in progress. Thanks to the advent of ETFs, you can immediately short any part of the market instantly, without having to wait for an uptick.
Shorting the S&P 500 via the ProShares Short S&P 500 (SH) is the simplest way. The SH gives you a hedge against the largest 500 stocks in the market and acts as a good proxy.
Because technology stocks tend to have greater volatility, you could instead (or also) short the NASDAQ 100 via the ProShares Short QQQ (PSQ). The PSQ would permit you to short the largest 100 tech stocks in the market.
If you want to broaden your hedge, short the Russell 2000 via the ProShares Short Russell 2000 (RWM). The RWM shorts the 2,000 smallest stocks in the market. In a crash, many investors choose to dump smaller stocks, which they view as riskier and more volatile, while holding onto their cherished blue chips.
How much should you short? A good rule of thumb is to short 20% of the total value of your portfolio. Of course, this might require you to raise cash to enter those short positions.
The first thing you should sell is anything you regard as a trade, a speculative purchase you’ve made or a special situation (like an anticipated merger). I would dump commodities to raise cash, because they are likely to get pulled down badly. Fears that a crash could lead to a recession and reduce demand for commodities would drive that decision.
If you are holding losses on any stocks, a crash is a good time to get out and harvest those capital losses.
Then, when things start to calm down, you can sell those short positions and use the cash to either reenter the positions you had exited or scoop up bargains.
Another approach is to purchase puts on the indices. I’m not fond on this angle, though, because by the time the correction is under way, the volatility will have increased to the point where those puts would be expensive.
Still, if that’s what you’re thinking about, you can buy puts on the SPDR S&P 500 ETF (SPY). Again, the SPY is a great proxy for the market.
You should also investigate other possibilities. Most importantly, do not panic. If you stick to your plan, you’ll come out just fine.
Lawrence Meyers does not own shares in any security named in this article.