Three Rules to Follow When You Start to Fear a Crash

By: Keith Kaplan

Jul 09, 2021 | EducationalInvesting Strategies

I’ve received a lot of questions recently about a potential market downturn.

When is it going to happen?

What are the warning signs? (We covered this recently.)

How should you handle your money?

Yes, stocks were down sharply again Thursday morning before a slight bounce higher in the final hours. And markets did cut some of the initial losses.

However, many people want to know down to the day if and when there is going to be a “market crash.”

I understand that sentiment. You want to protect the gains that you’ve made, and you want to protect your principal.

Here’s an important thing to remember.

Fear and pain are signs that you are investing well and making good decisions.

So, I want to give you three rules to protect yourself.

Yes, there might be a storm on the horizon. But remember the storm will likely just be temporary. And we don’t want to be focused on just the next few weeks. Instead, we want to focus on the long road ahead. So here’s what you need to know.

Rule One: Don’t Sell Because of Fear

One of the clumsiest things that people do is sell because of emotion. The truth is that you will never be a successful investor if you’re afraid of market pullbacks. There have been many temporary runbacks over the last 10 years. But the people who held the course enjoyed the benefits of the bounce back.

Charles Schwab recently did an analysis of portfolios among its investors. It found that over the past two decades, the S&P 500’s average return was roughly 6%.

However, investors might have missed the top 20 days’ performance if they had sold off and bought the stock back later. The average return for people who sold and bought back after those 20 days earned a paltry 0.1% each year.

The truth is that if you sell based on emotion and not on signals, you’re far less likely to buy back into the stocks you love to own at your sell-off price.

Remember, investing is a behavioral activity.

And mastering your emotions is essential.

There are tools in place to help remove the emotion of selling in a market. Each stock has a different volatility level, so each stock should have a different trailing stop. By using trailing stops, you protect gains as stocks go higher and ensure that you minimize your risk should they fall.

If you need to identify the right trailing stop for each stock, we’ve created a set of tools to make it as easy as reading a stoplight with TradeSmith Finance.

Rule Two: Know What You Need

You might be holding on to lots of dividend-paying stocks and others that have performed well for you in the past. Remember, the market is the best money-making machine in the world. But it’s also one designed to help preserve wealth.

So, if you’re tempted to sell, don’t sell more than you need. Think about your unique expenses. Think about your balance sheet. If you need lots of money while invested in the market, you might need to reassess how you invest.

Perhaps you should consider bonds, or safer yield-bearing assets that carry less risk. Your individual risk tolerance must match the investment strategy that aligns with your lifestyle.

Taking risks as an investor is essential. Typically, if you’re not worried, you’re not risking enough. But in down markets, reassess your goals, lifestyle, and what is reasonable for you for 18 months (the typical length of a bear market).

Rule Three: Actively Manage at All Times

If you know what you need and you have your trailing stops in place, now is a good time to start actively managing your portfolios a little more. One of the best things you can do is generate a bit more income while navigating this market.

Imagine that you have a stock that might be falling in recent days. A good example might be Enterprise Products Partners (EPD).

Let’s say you own 100 shares of EPD at $24.00 as of this writing.

The stock is in the Green Zone within TradeSmith Finance and has maintained strong upward momentum.

This stock would enter the Yellow Zone at $22.00; the Red Zone (where the stock would stop out) begins at $19.71.

Here’s what you can do.

You could sell a covered call on this stock.

This means you would sell a call option to someone else. The call option gives the buyer of that contract the right, but not the obligation, to purchase the stock on a specific date (the expiration date) at a specific price (the strike price).

Here’s why this strategy is smart. Right now, you could sell the $25 call option dated Aug. 20, 2021, for a $25 premium ($0.25 per share). This means that you receive $25 for giving someone the right to buy your shares in 42 days at a strike price of $25.

Now, $25 might not be such a big deal. But think about the scenarios that exist. First, if the stock remains under $25 by that date, you keep your shares and the $25 premium.

In addition, if the stock does go to $25 or more and you have to sell your shares, you will also receive a few benefits. First, it’s unlikely that the buyer will execute the contract before the strike price, so you should still collect the dividend paid on the stock at the end of July. It currently has a 7.36% dividend (you’d receive 45 cents per share [so $45 since you own 100 shares], or an additional 1.8%).

Next, your stock will have appreciated by more than 4% from current levels. And, as I mentioned, you will also keep the $25 premium. You’ll have the potential to make a pretty good return.

Overall, the maximum upside is $45 (from dividends), plus $100 from the share price appreciation from $24 to $25, plus the $25 premium.

That’s a total of $170, so you’re looking at a potential 7.08% return in 42 days.

But what about the downside? Well, you know your trailing stop is at $19.71. So you’re going to ride it out and not let your emotions take over. Remember, if the price of the stock falls, the cost of the option will decline as well.

If the stock drops from $24 to $23, the value of that contract that you sold will likely depreciate. And you can buy the contract back to close that position and pocket the difference between what you sold it for and what you paid to repurchase it.

You can continue to sell contracts at different strike prices on the way down (just make sure it’s one contract per every 100 shares that you own). Doing so allows you to generate additional income even if you’re buying and holding these stocks forever.

Selling covered calls is not just a strategy to make money if the stocks go higher. Instead, it is a strategy designed to help protect your money should these stocks pull back. We’ll talk more about other strategies to protect you all next week.

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