How to Protect Against a Market Correction
15 June 2017
The recent correction in the tech sector in the United States has raised fears of a potential wider and larger market pull back.
The view is that there will be a correction in the market at some point, as it is always a matter of ‘when’ and not ‘if’. We believe that it is important to avoid substantial loss in inevitable market corrections. This is because losses are exponential, the larger they are the greater amount an investor needs to make to break even on the original position.
If an investor loses 1% of their portfolio they have to make 1.1% to make it back. If they lose 5% they need 5.26% to break even. At 10%, breakeven is 11%. A 20% loss requires a 25% gain. If you lose 50% of your portfolio you have to make 100% to make it back. If the unthinkable happens and you lose 90% of your portfolio, an investor has to deliver 900% to break even.
Experienced investors know that making 100% and doubling their money is a lot harder than losing 50%. It is important therefore for investors to have a plan for when a market correction happens. Without a plan, a serious market correction can be like stepping in front of a freight train for investors. It is possible for a portfolio to recover from a small to medium sized loss in time. However, without extra capital it is extremely difficult for investors to recover from a substantial correction.
In this review, we will discuss various options that investors have for reducing the impact (and even
profiting!) from a market correction.
Raise Cash:
We have put this first because it is our preference during market corrections. The idea being that you sell some stock to increase the percentage of cash held in your portfolio and wait until a lower risk opportunity to buy back into shares. This could be after stocks become good value again.
Pros:
• Very easy to do and simple, easy to manage and adjust.
• Safe, cash does not carry the same risk as other methods discussed in this
report. You do not for example have unlimited upside risk on cash like you do
when shorting a stock.
• No monitoring, you do not need to read annual reports on cash or worry about
exposure. It generally just sits there.
• Interest, most cash will generate a small amount of interest in the bank.
Cons:
• It is not that exciting for enterprising investors. We generally see that for most
investors it is easier to talk about going to cash than it is to do.
• Cash is a depreciating asset. Long periods in cash will result in deterioration of
buying power because of inflation.
• Aside from interest it does not have profit potential like other asset classes.
Short:
Investors can profit from the depreciation in asset prices by going short a stock, index or exchange traded fund (ETF). Without going into the mechanics of shorting you are borrowing the stock from the broker, which essentially means that you are selling shares without owning them and profit if they lose value. For example, if you shorted 100 shares of XYZ at $10 per share and they went to $9 then you would make
$1 per share or $100.
Pros:
• Shares and ETFs tend to lose money a lost faster than what they gain. This
means that investors can make a lot of money in a very short period of time.
• Shorting makes it possible to profit in both bull and bear markets.
• In many cases you can protect upside risk by buying call options.
Cons:
• Shorting is easier said than done. Most investors find it psychologically difficult
to short companies.
• Unlimited upside risk. When you are long a stock it can only go to zero. If you
are short a stock it can theoretically go to infinity. This is particularly dangerous
with stocks that are takeover targets.
• If you have shorted a stock and it pays a dividend then you have to pay it.
Which can make many companies that pay dividends difficult to short.
• Shorting generally requires full-time portfolio management and should be left
to professional traders.
• You have to have a margin account with a broker and it is difficult for many
investors in New Zealand to access.
Derivative Financial Products:
Put Options:
Buying or going long a put option is one way that investors can profit from a declining
market or stock. If you own a put option this gives you the option to sell shares at a
specified price and a specified price in the future. For example, if an investor owned
one $9 put option for company XYZ that was trading at $10 per share this gives the
investor the right to sell 100 shares of XYZ at $9 per share. If XYZ had dropped to $5
per share on the expiry date of the option then the investor would have realised a $4
per share profit because they could sell something that was worth $5 for $9. To have
this right and to own the option the buyer pays the seller or writer of the option a
‘premium’ per share.
Pros:
• Risk is defined and known. The most an owner of a put option can lose is the
premium that is paid. Potential profit can be many multiples of the initial risk.
Investors can therefore achieve leveraged returns with minimised risk.
• Often allows investors to hedge specific stocks within a portfolio. For example,
if you owned 100 shares of XYZ then you could buy a put option in XYZ to
mitigate downside risk.
• Allows investors to potentially profit during market corrections.
Cons:
• Most put options expire worthless and buyers will lose the premium that they
have paid. Investopedia estimates that 76.5% of options expire worthless.
• Options are time depreciating assets. As the option gets closer to expiry date
they lose money in what is called ‘time decay’.
• Requires experience and practice. have not seen many novice options
traders make profits immediately.
Short Call Options:
Investors can profit by short calling options. This is done by taking the opposite side of the trade from investors than own call options. As buying a call option is considered bullish, selling a call option is bearish. Buying a call option means that you have the option to buy a selected security at
a specified price in the future of the seller or writer of the option. As the writer of the option you receive a premium in your trading account.
Pros:
• Most of the time a seller of a call option will make money. They receive the
benefit of ‘time decay’.
• Investors are able to use ‘covered calls’ to reduce downside exposure on
stocks.
• If an investor is very bearish they can use the premium received from call
options to pay for put options on a stock.
Cons:
• The maximum profit that can be received is premium that is received from the
option.
• Upside risk is same as being short a stock.
• Call options are usually written over 100 shares. It can therefore be difficult to
proportionately control risk when writing calls.
Gold:
This is our least favoured method of profiting from a market correction. This involves either purchasing the physical metal or by buying an intangible form such as a gold ETF or a gold stock. We only include it in this summary because of its popularity amongst investors.
Pros:
• Sometimes during market corrections, the price of gold goes up. Savvy
investors can profit from this.
• In 2017 with the various financial instruments that exist it is quite easy to do.
Cons:
• Gold is a non-producing asset. If you buy gold bars and put them in your gold
safe during a market correction at the end of the market correction all you
have is gold bars. Do not expect dividends.
• The view is that it is a stock market fable that gold appreciates during
periods of calamity. Sometimes this happens, sometimes it doesn’t.
“(Gold) gets dug out of the ground in Africa, or someplace. Then we melt it down,
dig another hole, bury it again and pay people to stand around guarding it. It has no
utility. Anyone watching from Mars would be scratching their head” – Warren
Buffett, does not advocate buying gold.
Summary:
There are many ways that investors can profit from bear markets (some not discussed
here include volatility and futures) but the most important thing is to have a plan.
If you share the view that bear markets are not a matter of ‘if’ then you ought to
be prepared. The longer you spend in the markets the more you realise that what can
happen will eventually happen. We prefer to increase our cash holdings during times
of crisis, we believe that because of its ease and safety it allows for clarity of thinking
that other investment classes may not offer. The level of which is dependent upon the
individual.
However, enterprising investors that are looking for increased returns or greater
portfolio protection may consider other financial instruments.