In sports, teams usually require strength from both the offensive and defensive players on a team. Without consideration for one or the other, it makes winning more difficult.
In hockey, for instance, you can form a highly offensive team that can score at will, but if that output dries up, then you run into problems. The old belief that a good defense wins championships is often valid.
This approach can also be used for the stock market, especially given the current situation in 2014, when trading is largely erratic and devoid of any strong sustainable direction.
Over the past four years, when the bull stock market was firing on all cylinders, just simply buying stocks was a no-brainer. The gains tended to come easily and quickly.
Yet here we are in what has been a frustrating year for the stock market after the stellar gains in 2013. In fact, just like my sports example, it’s time to review your defense and make sure you have set up the right formation in your portfolio should the stock market continue to waver.
We all kind of knew that it would not be easy for the stock market this year. At the beginning of the year, the negative start in January suggested that there was a 46% probability the stock market would decline this year, according to the Stock Trader’s Almanac.
So while the DOW and Russell 2000 are negative this year, there’s still a chance these key stock indices can rally and finish in the black by year-end. Considering that the S&P 500 is up about 180% since the beginning of the stock market rally in March 2009, you have to believe investors want to absorb some profits.
Now, I’m not suggesting the bull market is dead; I’m simply saying that we could see a pause and there could be more downside moves in the stock market when interest rates head higher sometime in early to mid-2015.
With the current 10-year bond yield at 2.45%, there’s a reason why investors are still sticking with the stock market.
So if you have not done so yet, it’s time to set up a sound defense that will help you avoid big losses and/or declines in the value of your stock market portfolio.
The easiest play for a good defense is to simply take some money off the table, especially on your bigger gainers.
You could also write some covered call options to play the potential pause in the stock market and generate some premium income at the same time.
Finally, a solid defense would not be possible without the use of a put hedge, which simply is the addition of put options on large stock positions or a market segment. Examples of these may be the PowerShares QQQ (NASDAQ/QQQ) exchange-traded fund (ETF), the SPDR Dow Jones Industrial Average (NYSEArca/DIA) ETF, the SPDR S&P 500 (NYSEArca/SPY) ETF, or the iShares Russell 2000 (NYSEArca/IWM) ETF.