Thinking about protection

The market is heading towards its seventh straight month of gains. Last year was an incredible year (mind you that was in part because we fell off a cliff at the end of 2019 and then snapped back in January and February) However, if you look over the last 5 years we have averaged a solid 10% return on the market. As of today, all three indices are up over 14%, with the Nasdaq up over 18%. The returns are great, and most of us traders are feeling pretty good about where we are. Which of course is why I am thinking about how to protect myself given that a 10%, or greater, slide is very likely. Maybe not tomorrow or the next day, but I feel like it has to come before the end of the year. This is despite the fact the economy is strong, corporate earnings have been great and the Fed is only just thinking about beginning to tap the breaks. After over 15 years of trading, I know something will happen to spook the market and it will drop. So what to do about it?

First, you should never sell into a downturn unless the entire financial system is about to collapse (see 2008). Given that situation is significantly less likely given the controls that been imposed on our banking system since then: Do Not Sell. The market has a tendency to come back, sometimes exceedingly fast, and if you sell you will not get back it at the price you sold at. Mind you, I am assuming that you do not have money you need to live on in the market - which is why I harp having a separate saving account. Without it, riding out a downturn may require you to sell things at a loss which is not good.

So how to protect yourself? First, you need to learn to take gains as you go, so you do not have huge gains in any single stock. Once I am done filling a stock position I want to have, I immediately think about when sell. Of course, each stock is unique. Some you may plan on holding forever because they pay a great dividend you depend on for income, others you may buy specifically because you want to trade them. As a rule, I always sell a third of any stock if it goes up more than 20% within the year I bought it. Yes, I have to pay the tax man, but I still make over 10% which is greater than the average annual market return (the don’t get greedy rule) A great return. The next third of the shares I sell when I reach a 30% return. The remainder I generally keep and just let ride, depending on the stock’s purpose in my portfolio and its momentum (a discussion for another day). Sometimes I end up using options to buy back the shares I have sold, but I generally set the option strike price at a level that gets me back in at what I originally paid. I frequently don’t get the chance to get back it, but I collect option premiums so I live with it.

So if you are worried about a correction, how do you protect the gains that have not reached the 20% threshold? This is where stop orders and options can come in handy. Let’s talk about stop orders first. Stop orders are orders that are triggered when a stock moves past a specific price point. Beyond that price point, stop orders are converted into market orders. You can put stop orders in for free on any stocks you own, but be careful. A stock can drop for any number of reasons, like a bit of bad press, and you may find your stop ordered was triggered, your stock was sold, and then it rebounded even higher. This can happen with volatile stocks like Moderna (MRNA). I only use stop orders on stocks where my remaining gains are in excess of 50% or more, and then I use trailing stop orders. These are stop orders where you set a percentage rather than a price where you will trigger a sale of your stock, usually at a 5% or 10% drop from the high point where it was trading that day. Obviously if your stock continues to rise, the price where your stop order is triggered rises with it. It lets you capture future gains in the stock.

I use stop orders very cautiously. I only have about two stop orders on the over 40 stocks I own. Volatility is the part of the market and I have had stop orders triggered only to regret selling when the stock rebounds and continues to shoot up. Mind you, as I only use stop orders on stocks where I have big gains, I usually console myself with that gain. But it is frustrating to see it continue to go up. There are other reasons I use for stop orders (stop losses they should be called) but I will save that discussion for another day.

My preferred way to protect stocks is using options. The simplest way is to buy a put option. Purchasing a put contract allows you to sell your stock to the seller at the strike price you have both agreed on. You will pay for the option, but you will have peace of mind that you will protect your profit on a particular stock in the event of a large downturn. Premiums for put options vary tremendously depending on the strike price and duration or the contract. You may want to save buying put options for those stocks where you have the biggest gains. You can frequently buy puts that cost less than 1% of the current stock price, particularly when market volatility is low, so it can be inexpensive to buy that peace of mind. If you do buy puts, go long duration (say three months at least) so you do not have to constantly check them. Plain old stop orders expire, so if you go that route you have keep them current.

Another way I use options to protect myself, is to sell calls. Selling calls helps in two ways. First, if I set the call strike price at a level that equates to a 20% gain, it forces me to sell, i.e, trim my gains, as I go along. Second, I write calls on almost all my positions, closing them when they are profitable to make a little extra money on my positions. If there is large sudden downturn, I can buy these call contracts back for far less than I sold them. This profit helps offset the sting of losses on my positions. Since I rarely if ever sell into a downturn, having these calls in place helps.

Market Today: Quiet day, slightly new highs for Nasdaq and S&P but the Dow faltered a little. Earnings season will finish up this week. Earnings create volatility so I usually make more on my options during earning season. My focus today was on Zoom (ZM), a stock I do not own yet but soon will due to a put I wrote over a month ago. I can write calls on it as it is very likely I will be put. (Some thing beginners should not do unless they own the stock). The company reported earnings today and it fell over 11% in after hours trading. It will make my call very profitable in the morning, and I am hopeful it will recover throughout the day as both earnings and revenue beat expectations. I will take a loss on ZM when I am put, but the money I have writing options on it will more than offset the loss and I will continue to write calls on it.