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5 Ways To Prepare For The Next Market Drop


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It finally happened. After years of nary a selloff, let alone a significant correction, the floodgates burst open.

On Monday, February 5, the Dow Jones Industrial Average suffered a mid-session 1,600 point death plunge. Buyers quickly entered the fray, with the DJIA closing down just 1,175 points, but the day was still the highest single-day point drop in history. Percentage-wise, the decline of 4.6% was the largest since the European debt crisis of 2011.

While nowhere near the carnage resulting from Black Monday, 1987 or the U.S. Financial Crisis of 2008, the wild price swings and surging volatility caught many investors off guard. Seven-plus years of every small selloff being quickly bought back up lulled investors into a false sense of security.

The Volatility Index (VIX), which measures volatility expectations, spiked to nearly 50 during the Monday plunge. This represents the highest percentage gain in the index's history at 84%, marking the fourth-highest close since its 1990 launch. Other historical VIX spikes include the Russian Ruble crisis of 1998, the credit crisis of 2009, and the 2011 S&P U.S. sovereign credit downgrade.

The VIX move is concerning as it may be a harbinger of things to come. Just imagine a similar selloff combined with a shocking economic or geopolitical event. The results could be devastating.

While the stock market is rallying back at the time of this writing, a similar or even much more severe drop could easily happen shortly. Here's how you can protect your portfolio against it.

1. Don't Worry
Despite the added volatility, fundamentals remain very solid. Corporate earnings are excellent and profitability is at its best level in over a decade. Even the overall market's price-to-earnings ratio is only slightly elevated above historical norms. With nearly 80% of all companies beating earnings expectations, the economy is very healthy.

While anything can happen, every major crash has been accompanied by dire economic news. This recent drop, however, was quite the opposite, with mostly bullish news around the globe.

On the other hand, the sharpness and severity of the plunge without a real reason could be concerning.

But the main reason prepared long-term investors to need not worry is that this has happened before. Despite it being the most massive point drop in history, single-day plunges of 4% or more have occured 37 times since 1987. And as you know, the market has roared back nearly every time.

2. Reevaluate Your Portfolio
Now is the time to take a close look at your stock holdings. Consider cutting back on your equity exposure to raise cash. Make sure you are well diversified across sectors and even internationally to help soften future plunges.

3. Add Insurance To Your Holdings
If you have a small equity portfolio, and LEAPSs are available on your holdings, purchasing one put LEAPS per 100 shares of each stock can be an inexpensive longer-term insurance policy against future volatility. If your portfolio contains a large number of stocks, consider put LEAPSs on the primary index ETFs best representing your holdings.

If LEAPSs are not available on your particular shares, regular put options can be used efficiently, just remember to roll them into the next expiration date so your "insurance policy" remains in force.

If you are an experienced, sophisticated stock market investor, you can also consider selling calls against the major indexes to create a steady income stream and also act as insurance policy should the bottom fall out.

There are a variety of variations on this theme, including collar strategies and covered calls. Use what your experience and comfort level dictates is best for your situation. For uninitiated, I explored some of these options in a previous article ( read it here ).

4. Lengthen Your Time Horizon
Buffett did not earn great wealth in a day and neither will you. The internet, direct access trading, and the 24-hour news cycle have encouraged an unhealthy relationship with time. Our society has forced everyone to desire quick results, which is a death blow for wealth building. Remember, there has not been a significant crash for a decade. After the last crash, the market went to all-time highs again and again.

The lesson learned is to have a long-term investment horizon, particularly after a market crash.

5. Buy, Buy, Buy
Bargains of a lifetime are often available after a market crash. Stocks that seemed unaffordable before suddenly become attainable. The old Wall Street maxim to "buy when there is blood in the street" rings true right after the stock market plunges. Historically, every plunge has seen stocks push to new all-time highs. Keeping cash at the ready to exploit such a situation is a promising way to long-term wealth in the stock market.

Risks To Consider: "The stock market can remain irrational longer than you can stay solvent." This famous saying comes to mind whenever one is anticipating a market crash. Many short-side players were burned badly as the stock market kept pushing higher than anyone ever expected.

The same thing goes for those trying to pick a bottom to buy after a crash. Always use stops and position size wisely no matter how sure you are of the future.

Action To Take: Prepare for the unexpected using the steps above.

Editor's Note: We've discovered the hidden signal that stocks give just before they take off. If you know how to read this "tell" it could mean $3,200 for you by next month. Full details here ...

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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This article appears in: Investing , Stocks


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