I recently had dinner with a friend who has a small business. This person is also an investor and has made some very good profits in the Fed-induced stock market. He is also aware that stocks have reached record heights due to the injection of easy money into the system.
The money made over the past four years in the stock market has not been that difficult, and therein lies the problem I continue to see every day: it has been a free ride in the stock market.
Many investors below the age of 25 probably have yet to experience a bear stock market. Of course, I’m assuming you didn’t have the capital to invest until you were around 21; but then again, based on the debt college students are accumulating, many probably still haven’t played the stock market.
I recall the situation was similar in 1987. Having started my first job at a bank in June of that year, I had debt and spent most of my earnings enjoying the good life. As a result, I was not impacted by the infamous crash of 1987, but I do remember the look on some of the older workers’ faces when the Dow Jones Industrial Average crashed and took with it the life savings of many investors.
So here we are. The S&P 500 and Dow traded at records on August 2. The Dow is down by more than four percent, and based on the investor sentiment turning neutral, we could see more weakness.
Going back to my friend, he asked me what he should do. I say take some profits, as I sense a bigger correction could be in the works for the stock market based on what I’m seeing in the retail sector. (Read “How Red Flags in the Retail Sector Are Threatening U.S. GDP Growth.”)
My friend really didn’t want to dump everything, so I told him to take profits on half of the positions that have seen any gains in excess of 100%. The rationale is straightforward: if you make over 100% and take profits on half of your position, you can let the other half essentially ride as free money. Of course, you should still have a stop in place on the remaining half to be safe.
Another investment strategy is to protect or hedge against a bigger downside move using put options.
Many of you probably already understand the concept of put options: you are basically buying insurance to protect a stock or group of stocks (index) against selling.
You pay the premium for the put options, and you make money on the options if the stock market moves lower depending on the cost of the premium. This helps to offset the loss on the underlying position. Of course if the stock market rises, you are fine and just lose the premium paid. Think of it as buying insurance on your car or home. If nothing happens, you just pay the premium. In the unfortunate situation that your car or home is damaged, your insurance pays the cost of repair. The same thinking forms the framework behind the use of put options.