Tags: Advantage | Sideways | Falling | Market

Three Ways to Take Advantage of a Sideways (or Falling) Market

By    |   Tuesday, 22 May 2012 08:43 AM EDT

Markets don’t hit a peak with trumpets and fanfare. Nor will you hear a warning bell signaling you to get out. Rather, markets will do pretty much what they’re doing now: fluctuate near their recent highs for a bit.

After peaking in early 2000, stocks pulled back a bit but traded in a range for over a year before falling much further, finally hitting a low in early 2003. The stock market traded in a range between May and November  2007. It peaked during that time. It took over 15 months before finally bottoming out in March 2009.

Other times, the market may trade sideways without a huge collapse. But investors won’t see huge rallies either. Whether the market is entering a prolonged sideways period or about to fall further, there are a few things you can do to protect your wealth—if not thrive—over the next few months:

1. Protect Your Gains. Take some profits on volatile stocks and re-invest in safer investments. After the market’s big rally since last November, it may be time to book profits, especially on stocks that have done substantially better than the overall market as a whole. By turning paper profits into real ones, you lock in and protect those gains.

2. Be Ready for Future Opportunities. Create a “watch list” of companies to buy as they get cheaper. You can get paid to hedge against a market decline by selling put options on companies you’re willing to buy at a lower price.

If the market stays sideways or starts rallying again, you can get a decent return on your cash without the risk of owning stocks. If the market sells off even further, you may get put shares at the option strike price. That’s why it’s important to only use put options on companies you don’t mind owning for the long haul.

3. Go Short. This is the riskiest strategy, and isn’t for most investors. But when markets fall, they do so quickly and painfully. Shorting the stocks of overpriced and overvalued companies (or buying an inverse fund that’s supposed to rise as stocks fall), can provide a source of profit while everything else is crashing.

In general, outright shorting is difficult and expensive. You have to find shares to short, and borrowing shares comes with a cost. You run the risk of margin calls. And even if a shorted stock goes to zero, your gains are capped at 100 percent, but your losses could be infinite. It’s easier to buy put options instead. You won’t have to worry about margin calls, and you can make more than 100 percent.

The old Wall Street saying is “sell in May and go away.” That’s not always true, but it is true often enough to warrant caution. With the market no longer rallying every day and volatility rising, it doesn’t hurt to take defensive measures against a broader decline.

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Tuesday, 22 May 2012 08:43 AM
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