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Old 06-04-2011, 09:14 PM   Nav to Top  #1
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Post Playing Defense in a Market Correction

For a few weeks I have been talking about how the market is due for a correction and been a very big cheerleader for playing defense with your portfolio. If you followed my caution and did what I suggested (or something similar) you would probably be buying me a cold beer if we saw one another. Last week was just brutal for the market and the averages. We had one of the biggest down days, 280 points on the DOW, in the last 2 years. From the weeks high to the close on Friday we lost over 400 points on the DOW and 45 on the S&P. Pretty bloody red week to say the least. The bad news is I still think we have farther to fall.

Most investors think of playing defense as a bad thing and do not like to do it. But in reality it is the one most important featany investor can do to beat the market consistently. Anyone can make money in a bull market when stocks are rising. But it is much harder to not lose money in a declining market. It is this conservation of money during a bear market that allows you to get higher returns over the normal investor or mutual fund. This is reiterated time and time again by Warren Buffet; and more people should follow his words of wisdom.

So playing defense really isn't that hard. The definition of playing defense really depends on the type of investor you are. If you do not like to play with options or short securities, the most simple one can do to play defense is raise cash. Remember, there is nothing wrong with selling a winner and taking profits. It is much better to take profits on a stock that is up a pay a capital gain tax, then to be stubborn and watch all those paper profits erode during a market correction. It sounds quite simple, but most do not do this. Another way to play defense if you are a conservative investor is to move your portfolio out of growth stocks with high betas into more defensive plays like consumer staples, utilities or pharmaceuticals. These companies usually pay hefty dividends that really reduce the downside risk while being paid with income while waiting on the market to come back. Now with the introduction of ETFs, any common investor can hedge their portfolio with a short ETF. One that I have used in the past is SDS. It moves inversely of the market, so if you purchase shares of the SDS and the market goes down as a whole, you will make money as SDS will increase in price. The last option one has is to purchase Gold. Gold is usually viewed as a safe haven in a bear market. This can be done with the GLD ETF or purchasing the bullion itself.

Now if you are a bit more aggressive of an investor, you can always short the market or individual securities. I would not advise doing this if you are fairly new to trading. The bad part of shorting a stock is the downside potential is infinite while you cannot gain more than 100%, and that would only happen if a company goes bankrupt. However, if you are comfortable with risk, then you can always make a solid return shorting a stock in a down market. A perfect example is OPEN. I have been writing about shorting it since right before their earnings when it traded at around $113 a share. Now it is trading at $85, just a few weeks later. Remember during a correction, the period of time for a big move is always much shorter in duration than the same move on the upside. More times than not, downside corrections are violent and can really test your nerves. At the same time, if you are short during this time, it can be extremely exhilarating!

The last way one can play defense is to use options. Once again, this is usually left for more experienced investors and most brokerages will force you to open a margin account to have access to trading options. With options, you can always buy puts, which is a bet on the underlying security going down, or one can sell calls which acts as like income if the security falls in price. Those are the two basic ways of trading options for defense in a down market, but there are thousands of possibilities with options using spreads, straddles, etc. I have been advising for these last few weeks on purchasing VIX calls. I have a boatload of these and during that one 280 point down day, the VIX jumped over 18%.

The last piece that every investor needs to do in playing defense is their homework for what they want to purchase when the correction ends. Usually corrections do not last more than a quarter on average and if you did a good job of raising cash and conserving for money, you need to know what you want to invest in when the bulls come back. This is called making a shopping list, and I will write on how to do that in my next article.

Until then, be careful and happy investing!


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GLD, open, SDS, VIX

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