While I’m writing this, Greece has yet to have a deal on the table. And the deadline for its June payment is next Tuesday. On top of that, there’s the overall uneasiness of the markets in general; which is why you, as an investor, need to have a strategy to protect yourself from a stock market crash, should it occur.
The U.S. Market Now
With the month drawing to a close next Tuesday, it has been pretty decent. In fact, new records have been established by the NASDAQ Composite and Russell 2000. Investors seem intent on moving capital back to the higher beta growth stocks in their search for better prospects.
Just look at what has happened this year. The NASDAQ is up nearly nine percent, easily outperforming the 1.7% advance by the S&P 500 and 1.6% by the Dow. The small-cap Russell 2000 is up just over seven percent this year.
On the charts, we are seeing an upward move in the stock market. An examination of all U.S.-listed stocks shows that about 64% are trading above their respective 20-day moving average (MA) versus 53% a month ago and 45% last week. The same pattern is also occurring for the 50-day and 200-day MA. Of course, this can quickly revert to the downside.
It seems investors are too wrapped up with the timeline of when the Federal Reserve will begin to raise interest rates. The point is: rates are moving higher. I surmise it will be only 25 basis points to start as Fed Chair Janet Yellen analyzes the impact on the economy.
What’s Going on with Chinese Markets
Across the Pacific Ocean, I’m becoming quite concerned with what’s happening in the Chinese equity market. Driven by massive margin finance loans and pure speculation that would make Macau seem like a dud, the Shanghai Composite Index with its surging China A-shares is up a whopping 140% at a time when the country is struggling for growth and spending.
Whichever way you look at it, Chinese mainland stocks are in a bubble that I believe will inevitably burst sometime this year. As I wrote in an earlier commentary, an example of a way to take advantage of a correction would be via put options or shorts in the DBX ETF Trust –Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (NYSEArca/ASHR), which is comprised of the A-shares.
Best Strategy to Protect from a Stock Market Crash: My View
The reason you need to be worried about China encountering a market collapse is that there will surely be a spread across the world stock markets, care of the interconnection between the world markets and economies.
There are five ways you can be on the defensive:
1. Simply lighten your load and wait for a potential stock market correction.
2. If the market pauses or threatens to the downside, I would be looking at establishing protective hedges via the use of put options on big stock positions or on indices. I’d label this as a simple strategy.
3. If you want to hold on to your stocks, you can write covered calls to generate premium income.
4. If you are interested in buying after a correction, you can set your desired price by writing put options. Not only do you receive premium income, but you also set a price that you’re willing to pay for a stock. As a result, its cost base is reduced by the premium received.
5. Now if you feel the stock market will break out in either direction, you can establish long straddles (buying a put and call with same strike and expiry) that benefit from a strong push in either direction. Conversely, if you feel stocks are stuck in the current range, you can write straddles and generate premium income. This strategy is risky, however, and should only be used by experienced option traders.