When the markets stop rising and begin falling, uncertainty and fear become major factors in trading activities. Watching the value of a stock or an entire portfolio erode as prices drop across multiple market sectors can certainly make any investor think twice about selling. For disciplined investors though, weathering the economic ups and downs is all part of the investment cycle and profits can be found at any point.
Slumps and pullbacks don’t have to halt your investment trading activity though. For the investors who keep a steady pace and avoid panic during sell-offs, downturns can often result in out-sized gains in the end.
Be sure to check our Portfolio Management Channel to learn more about different portfolio rebalancing strategies.
The Volatility Index
The Cboe Volatility Index® (VIX) tracks market expectations for the relative strength of near-term price changes in the S&P 500 Index. Put another way, it measures the level of volatility or uncertainty in the markets. While the index isn’t fool-proof for reflecting market volatility, the general rule of thumb is that anything under 15 means “low volatility,” while anything above 20 is interpreted as “high volatility.”
The best way to use the VIX is to treat it as more of a general barometer of volatility. It can give investors a good sense of how other traders are buying and selling and what the overall sentiment is. It’s important to note that volatility in and of itself isn’t necessarily bad. Larger-than-average swings in stock prices can generate many buying and selling opportunities that wouldn’t otherwise be available.
The Value Investor’s Market
The trademark of a good value investor is knowing when and where to find bargain stock pick-ups. Discounted stocks trading below their intrinsic value can be found in any kind of market, up or down. But as a general rule of thumb, the downturns are usually the best hunting grounds for these types of investors.
When others are selling, that’s when value investors like to be the ones buying. It’s one of Warren Buffet’s most well-known trading disciplines and falls under another Wall Street saying; “no one ever made a dime by panicking.” Stocks that are sold by worried investors who don’t want to lose money are prime targets of opportunity for bargain hunters.
Broad sell-offs triggered by fear or larger-than-average mutual fund share redemption’s can be one of the best value-inducing effects. If a stock falls due to missed earnings or increased competition in its niche sector, it’s safe to assume that the price decline is probably reasonable. But if it drops because of broad market selling activity that doesn’t have anything to do with that individual business specifically, then it creates opportunities for value hunters.
Long-Term Versus Short-Term Trades
The length of any particular trade becomes a more important factor in stock investment decision making during pullbacks. The amount of time required for an economic contraction to change into an economic boom is highly variable. For short-term trades, there may not be enough recovery time to realize a profit.
One way to protect your portfolio against losses due to market declines is to hedge your investments using options. Simple calls and puts give you the ability to speculate on potential trades without risking a lot of capital. And they can also be used in conjunction with stock holdings you already have in order to create a buffer against adverse price movements.
For example, let’s say you owned 100 shares of U.S. Steel (X) that you bought at $20.00 per share which are now trading at $21.70 per share. So far you have a potential profit of $1.70, or 8.5 percent. You decide to keep holding it but you’re worried about a potential pullback in the market so you buy a put option for October 21 with a strike price of $18.00 per share for a total of $1.02 per share. This locks in the maximum potential loss you could sustain for the time frame at just $2 per share: $20 bought – $18 strike = $2 maximum loss.
Conversely, you may decide that U.S. Steel is worth buying more of if it drops to $18 per share. In that scenario you could sell a put rather than buy one and get $1.02 per share in profit right up front. The downside to this trade is that the put must be exercised if it drops, at $18 per share. Even if it falls to less than $15 per share, you are obligated to purchase 100 shares at $18 per share.
Long-term investors have less to worry about since they can wait out market corrections without having to sell their holdings. That doesn’t mean there aren’t trades that could be made however. Dividend-paying stock holdings tend to go up in value during market corrections as investors seek larger yields to offset the drop in stock gains. It can be prudent to sell such a high-yield dividend payer when it rises due to greater investment demand and realize a bigger gain than you might otherwise have received.
Final Considerations
Market slowdowns and downturns aren’t a death knell for an investment portfolio. By holding on to solid investment principles, you can avoid taking losses from panicked selling and even profit by picking up good companies at cheaper prices.
Staying the course and maintaining your investment discipline is key to weathering any market downturn and avoiding costly selling mistakes. Tracking market volatility, spotting discounted stocks from broad sell-offs and maintaining smart short- and long-term trade strategies are the keys to not just surviving downturns, but thriving in them.
Make sure to visit our News section to catch up with the latest news about income investing.
