Profit From A Market Decline

| January 21, 2008 | 0 Comments

It's no secret that the market has been very difficult over the last 3 months.  We've seen the DOW drop nearly 9% so far this year and almost 15% since October.  So, as an investor, how do you deal with this “gloomy” situation?

As editor of The Option Forecast and a stockbroker for nearly 10 years before that, I've seen firsthand what these types of markets do to individual investors and their portfolios.

They chew them up and spit them out.

You've all seen or heard of the study done by Morningstar that showed that the average investor gets a lower rate of return than your average mutual fund, even if they are invested in that same mutual fund (the reason? the average investor gets nervous and buys at the wrong time and sells at the wrong time, over and over).

It's truly amazing how an otherwise sane investor will abandon his investment strategy and beliefs as soon as the markets (and his or her investments) hit a rough patch.  He or she will break all of the classic investment “rules” that they've spent years learning about, at the drop of a hat.

Now, rather than play psychologist and go into all the reasons why investors panic when their portfolios drop significantly, I'm going to offer an alternative.

But, before I discuss some strategies for keeping your portfolio out of trouble, I want to make a quick point that you all should be aware of.

Professional investors approach things differently.

Do you think accomplished investors like Warren Buffett, Eddie Lampert, and Peter Lynch panic and blow-out their entire investment portfolio (or completely change their investment strategy) because it goes down?  Do you think they ever say to themselves, “I'm not going to invest anymore because I've lost some money”?

The answer is no.  They either avoid or minimize the damage and then look for other ways to profit.  They didn't get where they are by giving up and following the herd.  They look for opportunities to make money while others are giving up.  That is how the big fortunes are made.

Ok, enough said about that.  Let's get to some real-life strategies that can help you avoid or minimize market declines and prepare your portfolio for future gains.

All 6 of these strategies help to hedge your portfolio against a market downturn.  The key is to have something in place that helps you avoid the catastrophic loss that knocks you out of the game, never to recover.

Lets take a quick look at these strategies:

Hedge #1:  Buy “defensive” investments

This is a strategy that you ought to employ at all times, in good markets and bad.  When times get tough, you want to make sure you own medical, healthcare, utility, and food stocks.

I don't care if you use individual stocks, mutual funds, ETFs, or options.  You need to have exposure to these sectors when things get rough (and remember, it's not like these things do terrible in bull markets either).

Hedge #2:  Buy call options on the CBOE Volatility Index

The CBOE Volatility Index tracks volatility in the markets.  As stocks fall, the VIX usually shoots up.  You can see from this chart that the index is up nearly 75% since early October.  If you have calls on this index, you can minimize the negative effect of a market decline on the rest of your holdings.

Hedge #3:  Sell covered calls

This is a very conservative strategy whereby you sell call options on stock you already own.  You get the income upfront in exchange for sacrificing upside potential on the stock should it rise above a certain level.  If your stock holdings fall, you get to keep the entire income from the call option.  The net effect is a hedge against market decline.

Hedge #4:  Buy put options

When trouble visits the markets, you can buy protective put options against your holdings.  Put options serve as a type of “insurance” in a declining market.  The gains you see in the puts offset some of the losses from your stock or mutual fund holdings.

Hedge #5:  Buy “inverse” ETFs (exchange traded funds)

There is a relatively new class of investment that allows you to “short” an entire market or sector by buying an ETF as you would a stock.  These investments rise in value when the security or market they're tracking declines in value.

For example, the ShortDOW 30 (symbol: DOG) will rise in value when the Dow Jones Industrial Average falls.  They also have the ShortQQQ (symbol: PSQ) for the NASDAQ, and the ShortS&P 500 (symbol: SH) for the S&P500 .  These investments make it very easy to short the market and hedge your portfolio.

Hedge #6:  Own both call and put options at the same time

This is the strategy we follow in The Option Forecast.  It's a little too complicated to get into here but we basically own a portfolio of both call and put options at the same time (on different stocks).  This unique system is designed to keep you protected in down markets without sacrificing upside potential.

The Moral of The Story

The point of this article is a little different from most.  It is my belief that you need to hedge the market not because of what is happening with the market, but because of what is happening within you!

Studies show that when investors get “wiped out” they never re-enter the market in a meaningful way.  They're always left with that bad taste in their mouth and end up telling anyone that'll listen that “investing” doesn't work.

If you can avoid catastrophic losses, you'll be able to keep your head and profit from the markets both today and in the future when things turn around.

We all know that the long-term trend of most markets is up.  So your goal should be to stay in the game long enough to take advantage of that trend.  And the way you reach that goal is by hedging your portfolio in one manner or another.

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Category: Stocks

About the Author ()

The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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