Some say the stock market will continue to rise, driven by the Federal Reserve’s likely strategy to maintain its low interest rates for another two years. There are those nervous about the tapering, but I don’t really care about that; in my view, the low interest rates are much more critical.
The stock market participants are now faced with a dilemma of whether to chase equities higher. With the gains we have seen, it makes sense to take some profits.
The reality is the broad stock market strength has also rewarded weak companies, which have been supported by the overall enthusiasm to buy stocks.
Some traders are looking at the short side, especially the hedge funds that believe the stock market is overvalued. The problem is that short-selling is not easy, especially in this kind of market. It has been difficult to make money from the short side, and as long as the bullish bias holds, I expect shorting will continue to be a tough path to making money. (Read “How to Profit by Buying ‘Bad’ Companies.”)
A better alternative to shorting individual stocks or indices would be to play a possible stock market correction via the use of bearish exchange-traded funds (ETFs), such as the Direxion Daily S&P500 Bear 3X Shares (NYSEArca/SPXS).
You can also play a possible stock market correction via the use of put options.
As a hedge, you can buy downside protection for your equities by buying put options on your stocks, a certain sector, or an index, such as the NASDAQ, Russell 2000, or S&P 500. This strategy is pretty easy, and it allows you to have some protection in exchange for paying a premium.
Another strategy you can use to play a possible stock market correction is if you want to buy stocks on weakness. If you are looking to buy on a market dip, you can wait for this to happen or you could write or sell put options on a particular stock you are interested in or an index. Under this strategy, you essentially set the buy price for a certain stock or index.
For instance, say you want to buy Facebook, Inc. (NASDAQ/FB) but not at its $47.00 share price as of Thursday. You feel the stock market or Facebook may head lower for a buying opportunity. Say you feel a correction is coming by February 2014. You determined that $38.00 is what you want to pay for Facebook. You can sell the February 2014 $38.00 put option and receive $1.09 per share in premium income. By selling the put, you are liable to buy Facebook should it fall to $38.00. Add in the premium, and your adjusted cost, should this happen, is $36.91 per share.
Of course, you can always take profits in cash, and avoid the sleepless nights.