Finance

Don’t be a sitting duck when this stock market rally fades — here’s what you should do now

Stock investors got a dose of harsh reality earlier this month when the major US market indexes declined and took many of their favourite stocks with them, including the so-called “generals”: Facebook, Amazon.com, Apple, Netflix, Alphabet, Walt Disney, Intel and Tesla.

The three-day selloff was a stark reminder that stocks are not bulletproof. One catalyst in this case was US inflation spiking to a 13-year peak. Institutional investors do not take kindly to inflation and they sold.

Then stocks rebounded over the final two trading sessions of the week ending 14 May, recovering much of the earlier losses and bringing the major indexes above their 50-day moving averages.

Keep in mind the main goal of investors and traders is to reduce or limit risk; the second goal is to make profits. After a wild start to the month and an unstable market, here are six ways to make sure your investment portfolio is positioned appropriately to the market’s moves:

Firstly, if indexes fall below their moving averages, take action. Traders and investors alike should watch moving averages, especially the 50-, 100-, and 200-day. When the indexes were sliding a few days before, the S&P 500, for example, did not break its 50-day moving average at 4,050. If it had and had stayed below the average, that would have been a strong sell signal. Now, from a technical standpoint, the S&P 500 must remain above 4,125 for the bulls to keep control.

READ Fund managers sell tech, buy UK as inflation fears mount

Whenever the major indexes fall below their 50-day moving average (red flag), the 100-day (big trouble) or the 200-day (welcome to the bear market) and stay below, smart investors consider cutting some of their long positions. The last thing you want is to be caught off guard.

Secondly, stick to your investment plan. If you don’t already have an investment or trading plan, make one. Evaluate what you own, cut losers that have little chance of rebounding and make sure you have diversified your assets.

You must create a plan based on facts, not emotion. If you do not have a plan, then you are susceptible to giving into fear and selling when the market plunges, or buying in a panic when the market rallies. Investing or trading based on emotion is a loser’s game.

Another reason for having a plan is to be prepared for a worst-case scenario. Your plan is like an insurance policy and should be reviewed annually at least.

Thirdly, dollar-cost-average into index funds. If you are a long-term investor or a trader, consider dollar-cost-averaging a preset amount every month into a low-cost index fund, such as a basic S&P 500 index fund.  That way, you are buying at lower prices when the market slumps and at higher prices when the market rallies. If you are a trader, you should also use this strategy. Why? Because the key to success in trading, investing and in life is diversification.

Fourthly, diversify. There are three major rules for investors and traders: sell losers; reduce or manage risk; and diversify your investments. Diversification simply means not putting all your eggs in one basket. Have a core mix of stocks and bonds and a portion in alternative investments. Sell covered calls (more on this later). Own real estate. And be sure to keep a healthy amount of cash for emergencies — and for bargain-hunting in market declines. By diversifying, you can survive the market’s pullbacks or even a bear market.

Fifthly, buy the big dips. Investors who missed out on the rally are waiting for the indexes to decline significantly so they can buy stocks cheaper. The market is an auction and right now it trades near all-time highs.

READ Fund manager heavyweights fret over ‘worrying’ inflation threat

Trying to time the market by buying the dip is not easy because you never know how low stocks or indexes can go. If you do, do not buy on the way down (trying to catch a falling knife is dangerous). Confirmation that the market has stopped its fall will be made when prices go sideways for a while.

Lastly, sell covered-call options. One of the safest option strategies is to “rent” your stocks to option speculators. With this strategy, you sell “covered-call” options on stocks you own. You receive premium for renting your stocks, but in exchange you give up control temporarily of when the stock is sold.

This isn’t a strategy to use when the market or your stocks are volatile (like now). However, it is worth exploring during flat or moderately bullish market environments.

Was this most recent market selloff just a three-day blip or a sign that worse days are ahead? If you are a trader, you will take advantage of increased volatility to try to make daily or weekly profits. But for most investors, the answer is elementary: reduce risk by increasing cash. This bull market is showing signs of slowing, especially since many of the strongest stocks are faltering.

Often, these one-or-two-day selloffs have been a gift to buy-the-dip investors, but this is also a dangerous manoeuvre to adopt should a sharp downdraft or freefall materialise. One of these days the market will plunge and keep plunging — catching buy-the-dip investors off guard. That is when you will be glad you have a plan, a diversified portfolio and plenty of cash.

Michael Sincere (michaelsincere.com) is the author of Understanding Options and Understanding Stocks. His latest, Make Money Trading Options, introduces simple option strategies to beginners.

This article was published by MarketWatch.

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