We know that markets do not go up every single day. But when we’re treated to several easy trading days in a row, it’s easy to fall into a complacent mindset. And if we’re suddenly faced with a market correction – like last week – our portfolios get clipped.
And far too often, I’ve seen traders respond to a correction with a stubborn and irrational stance. You can’t bully the market to do as you will. That is a recipe for disaster.
How to protect your portfolio during a market correction
Two words: Be prepared.
I’m from California, the heart of earthquake activity in the US, and we were taught to always be prepared: Have a fire extinguisher, first aid kit, battery-powered radio, flashlight, and extra batteries and learn how to turn off the gas, water, and electricity. You cannot predict an earthquake, but if you’re prepared, your odds of survival increase.
Trading is no different.
Hold cash
I advocate holding high levels of cash at all times (good, bad and ugly). When the stock market starts to wobble, increase that cash position. Cash is a great defensive play, because it affords you the luxury of waiting out the storm and puts you in a position to pick up stocks at bargain prices.
How much is enough cash? I always tell people not to trade more than 3% of your portfolio value at any one time. During a correction, you may want to reduce that level to less than 2% or even less than 1%.
Buy index puts
I also suggest holding index puts to protect your portfolio against volatility.
During a market correction, volatility rises. This simply means that indices will move up and down in a wider range. Likewise, our long positions will move around quite a bit more than usual. Index puts blunt the effects of volatility.
You may not make money on the puts, and frankly that’s okay. If the bulls start buying up the market, the correction may become a thing of the past. But as long as there is volatility, there is uncertainty. The stock market hates uncertainty.
Market corrections come around every so often, usually unannounced. If you hold plenty of cash and carry a few puts at all times, those nasty days won’t hurt your bottom line quite so bad.
