How to Keep a Cool Head in a Market Correction

Don't panic during a market correction. Here's a solid strategy, as well as a few deep discounts to be on the watch for.

Did you expect a stock market correction on Monday, as I suspected last Friday that we might see one? What did you do when you woke up, as I did, to the Dow Jones dropping more than a thousand points?

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Did you panic? Did you sell everything? Did you pick up stocks on the cheap?

When faced with a stock market correction, emotions can get the better of even the most experienced investor. But as an investor with 20 years experience and more than my share of stomach aches, I developed a stock market correction protocol for days just like this.

Here’s what you should know:

Stock Market Correction Protocol

First, if you are a long-term investor with a broadly diversified portfolio, you’ve already given yourself the best protection for a stock market correction — diversification. So stay calm, and certainly don’t engage in undisciplined panic selling. After all, you’re in it for the long haul. The market is just giving up a small part of its gains from the past seven years.

However, a stock market correction is a good time to re-evaluate some new positions you may have, or stocks that are within 5%-7% of your buy point, either up or down from where you purchased them. While you shouldn’t sell all willy-nilly, you can sell for a purpose — namely, to raise some cash to put to work on other bargains should the market go even lower.

The idea is that you aren’t abandoning your long-term holds in a stock market correction, but exiting trades to raise cash for better upside opportunities.

Exit all speculative positions during a stock market correction. These are the flyers you are taking on stocks — long or short — that are not investments so much as bets on some event you think may occur. The idea is that rather than speculate, if prices fall far enough, you can put that money to work with more solid bets.

Consider selling positions that you have a loss of 5% to 7% on. First, you’ll be able to capture capital losses that you can write off against gains, which is never a bad thing. Second, in a market correction, those positions will continue to lose value. Why not sell now and buy back in at lower prices?

Similarly, consider selling positions that are profitable by 5% to 7%. The idea is to preserve some capital without significantly altering your position.

Now, using some of the cash you’ve raised, consider opening some short positions on the broad market. After all, you may as well profit if the market is going to fall. My three go-to short trades are ProShares Short S&P 500 (SH), ProShares Short Russell 2000 (RWM) and ProShares Short QQQ (PSQ). You are now short broad parts of the market, which will hedge your long-term portfolio.

I set a 7% stop-loss on these short positions. I expect the market to snap back a bit, as it did on Monday, as buyers step in to buy some of the sharp dips. A 7% stop-loss is generally large enough not to get caught in these rallies, but will get triggered when the market recovers for real.

Now comes the tricky part — buying for your long-term portfolio.

There’s no answer as to when the moment comes to step in and buy. It takes guts. What I do is calculate how much money I have to go long with, including the cash I would have when I close out my short positions.

Then I would very slowly scale into stocks you want to buy. If you normally buy 100 shares of something, buy 10. Just nibble. The idea is you are expecting to average in, not catch the exact bottom.

Keep your short positions in place to give you some cover if things fall further. At some point, you’ll need to cover. As with purchases, don’t cover all at once. You won’t catch the bottom. Cover after a huge downdraft in pieces.

Stocks I would love to get for my long-term portfolio are …

For a trade, Netflix (NFLX) will fall quickly but recover quickly.

Good luck and keep a cool head.

Lawrence Meyers owns shares of AAPL, DIS, ENVA and LUV, but these positions may have changed, and other names may have been purchased between the time this article was written and when it was published due to market conditions.

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Article printed from InvestorPlace Media, https://investorplace.com/2015/08/stock-market-correction-protocol/.

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