If you think this last correction was “it” for 2018, you’re probably not on the same page as I am. Sure, it could be this year’s only correction, but chances are that it isn’t.
According to current volatility trends, the markets are not convinced that this recovery is sustainable. In past corrections, volatility has returned to close to where it was prior to the correction within about three weeks. In this case, it’s been two weeks and that still hasn’t happened.
So it’s time for you to add a little defense to your portfolio. The best way I know how to do this, other than selling stocks outright, is to be short some positions that will give you a bigger bang for your buck when the market or specific shares decline. They will hopefully offset any losses from your long positions.
But while selling stocks short is a fool’s game, buying put options on stocks is not. Let me explain.
When you sell short a stock, you must borrow shares from your broker, then sell those shares into the market. The goal here is that in a few weeks or months, the price of the stock will decline to a point where you can then buy the shares in the open market and replace the shares that you borrowed.
All your broker cares about is that you replace the same number of shares that you borrowed. He does not care about the price of the stock. That risk is yours.
Of course, if the shares fall, you make money by buying cheaper shares to replace the ones you borrowed. If the shares rise, you are going to take a loss. If the shares really rise, you’re going to take a bath.
Think about those Monday morning opening trades on some biotech stocks or takeover announcements. When those happen, the underlying shares can soar by triple digits. Every dollar the stock moves higher is a dollar you are losing. In theory, your losses could be unlimited. That’s why short selling can be dangerous.
But there is another way to claim massive profits and enjoy limited risk at the same time.
That way is buying put options. I use them all the time to bet that the share price of a company is heading lower. If I buy a put for $1 on a $20 stock, betting it’ll fall to $15 by expiration, I can make five times my money if it happens. If it doesn’t, the most I can lose is the $1 I invested. My risk is limited.
But buying any option without a strategy, whether it’s a put or a call, is for the birds. You must have a system in place – and that system can’t be a tip from your third cousin who knows someone on Wall Street.
Look for opportunities at companies that are terribly run, where earnings are projected to fall, where trends like automation or online platforms will put them out of business. Look for trends in the company’s metrics quarter over quarter and year over year. This type of research, combined with a limited-risk strategy, is what can make you significant profits in a market that is now unsure of its direction.