I have been pleasantly surprised with the stock market. Incredible does not seem like strong enough of a word to describe the nearly decade-long bull market we're in.
Despite the roaring market, stocks never go up in a straight line. There are always pullbacks and sometimes severe plunges, even when everything looking super bullish. In fact, the worst plunges occur when investors are complacent and not expecting a selloff.
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And if there ever were a time of investor complacency, it's now.
Today is the perfect time to review your portfolio to make certain it is protected against the downside. If the move higher is any indication, the move back down could be brutal.
How You Can Protect Your Portfolio
1. Buy Insurance
Believe it or not, there are ways to insure your portfolio from losses. But these are far from traditional insurance plans.
Options contracts can act as an insurance policy against downside in your portfolio. My favorite way to do this is via Long-Term Equity Anticipation Securities (LEAPS).
Regular put options can be used for the same purpose. They cover smaller amounts of time, but usually cost less. The downside is that they require more active management.
The strategy is executed by buying one LEAPS put or regular put per 100 shares of stock. In a large portfolio, this can become cumbersome, particularly if LEAPS or put options are not available on your holdings.
In this case, you can purchase puts on the index ETF best representing the makeup of your portfolio. For instance, if your portfolio is mostly domestic large-cap stocks, buy puts or LEAPS puts on the S&P 500 SPDR (NYSE: SPY). If you own a majority of international stocks, the iShares MSCI World ETF (NYSE: URTH) can work. There is an ETF for nearly every type of portfolio that can provide the insurance you need.
2. Protect Gains For Free
One of the coolest things about using options and LEAPS to protect your gains is that it doesn't need to cost very much -- or anything at all. While it is not applicable in every circumstance, you may be able to use a strategy known as a "collar."
A collar is the concurrent purchase of a put or put LEAPS and the selling of a call or call LEAPS. The idea behind the strategy is that the premium received for selling the call pays for the protective put. Generally, the options have identical expiration dates. The ratio is also the same -- each contract covers 100 shares of stock.
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For example, if you own 1,000 shares of XYZ, a collar would consist of buying ten put options and selling ten call options. The options are purchased and sold for the timeframe in which you wish to protect your downside.
3. Use Stop-Loss Orders
While this strategy may go without saying for some of you, I am always surprised at how many investors fail to use stop-loss orders in their portfolios. Now is the time to take a close look at each of your holdings to make certain you have a stop-loss set at your desired profit-taking level.
The smartest way I have found to use stop-loss orders is via trailing stops. A trailing stop moves higher as the price of the stock moves higher. Nearly every online investing platform has a very simple way to set a trailing stop on your stocks. You simply choose the distance from the current price you wish (usually as a percentage) and it will automatically follow the price at that level. Trailing stops allow you to participate in additional upside but will protect your gains if the shares start to reverse.
The distance between price and your trailing stop is a personal decision, and I like to look at each stock individually. Generally, I use very wide trailing stops around 10% away from the share price. This allows for natural price volatility while still protecting the majority of the profit. One can also use the Average True Range (ATR) of the stock to set trailing stops.
4. Raise Cash
The best thing about a market selloff is opportunity. Stocks become relatively cheaper after a plunge, creating what could be a great time to buy.
Consider taking profits on several of your top-performing names now to raise cash. Having the cash to deploy back into the stock market after a sharp correction is how stock market millionaires are created.
Risks To Consider: The risk to protecting your downside is often missing out on possible additional upside. While risk can be managed, no one knows what the future holds. Each investor must proceed based on his or her own personal circumstances and goals.
Action To Take: Consider implementing one or more of these strategies to protect your portfolio from the demise of this raging bull market.