OptionAlpha | Original Link
The further the markets continue to run higher, the greater the risk that another major market correction or market crash will happen in the near future.
The stock market has fallen 9 times at least 30% which is once every 10 years.
Right now we’re riding a 10-year bull rally that’s losing steam fast.
So, how do you protect your portfolio in a down market?
- No two crashes or corrections in the market are the same.
- The statistics on market crashes and how often they happen are all generalities until we go through the next event.
- The only thing we do know is that markets are cyclical: it is impossible to have a market that goes straight up and straight down.
- Statistically speaking, we are pushing the boundaries of where we can see another correction occurring.
- Black swan events correct markets and keep everyone honest about how they trade and how much risk they take on.
Market Data from 1928:
- 21 times in history stocks have fallen 20% at least, which is once every four years.
- 41 times in history stocks have fallen 15%, which is once every two years.
- 9 times stocks have fallen at least 30%, which is once every 10 years.
Black Swan Safety Plan:
1. Heading into a crash, you need to have a lot of cash.
- Anyone with cash heading into a market correction is better off than somebody who is fully allocated.
- Cash allows you to be more nimble and more aggressive after a crash.
Gives you the ability to cover your position and also to expand and add new positions.
2. Generally, crashes happen in slow motion.
- Rarely get an entire market that will crash overnight.
- Most of the time market crashes happen in stages.
It is okay give yourself room to wait for the crash to happen and not to over-anticipate its occurrence.
- As options traders we have time to adjust and move around the crash.
A False Sense of Security:
“Market crashes have a tendency to unfold after the market has lost a 10 or 15% correction and then recovered from those lows.” – John Hussman
- The markets tend to crash, and then bounce back off of that drop almost recovering completely.
- This creates a false sense of security, drawing traders in to “buy low”.
- Then the market experiences the actual big crash after the initial dip down.
Market Crash Statistics:
“I counted 24 instances of a drop of at least 10% in the last 30 years. The mean average drop is 17.7% over 11 and a half weeks and the median is 17% over the 8-week period.”
- It takes some time for the markets to realize all of the information and for that information to be disseminated against the masses.
- However, individual securities can definitely crash overnight.
What does that mean for options traders?
- Most trades are around 40 to 45 days out.
- Might get stung one month heading into a crash situation that you do not know is happening.
- However, if you keep trading neutral you can keep adjusting along the way.
- As stock traders you do not have that choice; Index trading is really dangerous because it has such a big downside.
3. Stick with the program and don’t assume that a bottom is in or not.
- You cannot assume that a market bottom is in.
- Always fun under the assumption that at any time the markets could drop.
- Still need to maintain a neutral balance, slightly bullish in some areas.
- Stick with the program, stay neutral, and when the market correction comes you’ll have an opportunity to adjust.
4. Scale up position sizes and maintain a balance during a down move.
- Slowly scale up your position sizes when the market starts to crash.
- Maintain balance; trade the direction of the market.
- If you are neutral and the market goes down, add more bearish positions in your portfolio.
Example: Heading into the market dip that has not yet occurred, your portfolio is totally 100% balance. Meaning, if the market stays right here, you generate the most amount of money possible on your trades. If the market drops 5%, then your portfolio still has its center of profit, its top of it’s bell curve, higher than where the market is right now. If the market drops and you’ve done nothing, then you are naturally bullish just based on the way that the market has moved. If you “buy the dip” and then the market continues to go lower, it digs you into a deeper hole.
5. Use costless collar for your stock positions.
- If you have a stock position that you want to maintain in the market, use a costless collar.
- You want to protect your portfolio without paying the “insurance premium” that it costs to do this.
- Use covered calls and costless collars to protect your position and reduce cost basis.
— The Option Specialist