If your portfolio is caught in the wrong direction, consider hedging to minimize some losses. This is a very basic strategy I use when I have plenty of cash, yet my portfolio is still caught in one direction while the market is headed in the other direction.
For example, if you are net long, you’ll want to hedge your positions by putting in a small short position in the indexes. If you chose the right longs (good charts before the sell-off and good quality companies), they should bounce strong with the next market bounce. However, if the trend is still down, you want to hedge for more pain to the downside rather than trying to call a market bottom and add to your longs. By averaging down rather than hedging, you continue to bet more and more on the losing direction which can drain you of capital very fast. Hedging allows you offset and take a breath as if we continue to fall, your hedge will start offsetting the losses from your longs. Now you start trading around a core position with those until you recoup your losses or until you gain a better edge in the markets.
Basically, instead of averaging down when caught long in a market that is selling off, consider buying an index short such as ProShares UltraShort Russell2000 (TWM) or ProShares UltraShort S&P500 (SDS)as the momentum pushes the markets low. This means if we keep falling, the shorts can start to offset your losses to the long-side giving you some breathing room and a clearer mind that should be freed from panic-drive thoughts. At this point, you can start trimming profits as we fall more and when things settle down, you can start taking those profits and adding back to your longs at a price that is averaged down yet safer to add. So now when we bounce, you can reduce “some” longs (doesn’t have to be fully green to reduce your position, use strength to reduce regardless). Now that you reduced some longs, you can add back to your shorts if the market is still uncertain. Keep working this strategy and if the volatility lasts long enough, you should be back to even or at least in a much better position by the time the market calms down without draining all your cash reserves by betting on only one direction. This is a good strategy to utilize when the market is becoming too hard to understand and you don’t want to go 100% cash with losses incurred.
Do this until the path becomes clear on which direction we are going to continue to run, but make sure you trade around a core position when one direction is showing strength. Leveraged index shorts like the ones listed above decay in value over time, but by trading around a core position locking in profits on strength and adding back on weakness, you start to negate that time decay. Basically, this strategy just buys you some time to figure things out while reducing/protecting losses rather than a strategy that will make you profitable over the long-haul. This strategy won’t work if you do not have significant cash though, so if you’re near fully invested in the markets, consider raising cash instead and take that as a lesson learned. This strategy is best implemented for when you are only partially invested (think less than 30% or 40%).
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Keep in mind, you can use options as well, but my point is outlining a very basic strategy.
As always, do your own homework to see if you agree. Good luck out there.
Mike
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