The October volatility was the result of many things, depending on who you ask. Was it jitters ahead of the midterm elections? A reaction to U.S.-China trade tensions? Underwhelming corporate earnings?
Regardless of the root cause, most people agree what October was: an opportunity. Traders feast on volatility, and that’s been hard to come by the last few years. October was only the fourth red month for the S&P 500 since the start of 2017.
The fact that the market has gone green this month just goes to show how preciously rare these opportunities can be. Don’t let the next volatile spell catch you off guard. Here are three ways for both traders and investors to take advantage next time the market goes down.
Of course, this is easier said than done with the benefit of hindsight, and it’s impossible to know when a bottom will occur. BUT, in the entire history of the stock market, every market pullback, correction, and bear market has proven to be an opportunity to buy the dip. Even the 2008 financial crisis, as scary as it was for the U.S. markets, was a tremendous buying opportunity for the most patient long-term investors. Shares of JP Morgan went down to $12. Amazon was $35. Netflix, on a split-adjusted basis, was $2.55. Google hit $123.
When the market goes through a cyclical downturn, even the highest-quality stocks take a beating. Long-term investors like Warren Buffett treat the opportunity like a Black Friday sale on Wall Street. If there are any quality stocks that you’d love to own, corrections present a great time to take money that you don’t need for a long time and put make some buys on the cheap.
In addition to playing the buy-and-hold game, you don’t need to be patient to make money in a bear market or correction.
Short sellers can profit in any type of market environment, but corrections are a short seller’s bread and butter. When the market is unstable, and the economy is weak, money tends to flow out of unprofitable companies and companies with high debt loads. These types of companies may have difficulty borrowing money if credit markets tighten, and investors tend to circle the wagons by dumping high-risk stocks and buying blue-chip names. Short sellers willing to go out on a limb and put some capital at risk can make major returns betting against companies with weak balance sheets. But don’t short a stock without first understanding what you’re risking.
There are several great option strategies for bear markets. For example, buying put options with relatively near-term expiration dates to capitalize on bearish momentum while simultaneously buying call options with relatively long-term expiration dates is a way to short the market in the near-term while hedging against a market bounce and betting on a longer-term recovery.
In addition, writing covered calls is a strategy that can work regardless of what the market is doing. In a bear market, writing out-of-the-money covered calls against core stock holdings allows you to immediately pocket the option premium no matter what. If the underlying stock price remains low or continues to drop, the calls expire worthlessly and the premium at least offsets some of the losses.
If the stock recovers, you earn profits on the stock all the way up to the strike price while keeping the initial option premium. The only downside is that any gains above the strike price are lost and you may be forced to sell your underlying stock position if the call option is executed.
As bad as October was, the S&P 500 has already regained about half its losses in the month. Whether that recover continues is anybody’s guess, but if it doesn’t, don’t let that scare you. Short-term corrections and long-term bear markets are part of the natural economic cycle. Just because stocks are losing value, doesn’t mean you can’t profit.
Disclosure: the author holds no position in the stocks mentioned.
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