Markets

Warning: This Could Make The Correction Much, Much Worse

The S&P 500 is close to 10% off its 52-week high, while all of its sectors are in the red for the year. Meanwhile, the small-cap Russell 2000 is teetering on the edge of a bear market.

Stocks are at a critical point. They could rebound as they have over and over in this seven-year bull market, or we could be facing a major correction.

One important piece of data coming out this month could be the straw that breaks the market's back and sends stocks tumbling.

Market Head Fake Or Heading Down?

Investors have enjoyed a great ride over the past seven years, though it hasn't all been smooth sailing. The S&P 500 has undergone a 10% correction in three of the past five years. While the market recovered each time, rewarding investors with the guts to stay in, there is good reason to believe we won't be so lucky this time.

On Monday, Alcoa (NYSE: AA ) kicked off the unofficial start to the fourth-quarter earnings season. FactSet expects companies in the S&P 500 will show a 5.3% year-over-year decline in profits. If earnings do come in lower, it will be the third consecutive quarter of falling profits. Corporate management is extremely pessimistic, as 83 companies issued negative guidance a just 28 issued positive guidance.

In the face of struggling corporate profits, the most recent payroll report showed a strong employment picture with 292,000 jobs added in December. This is good news for the economy, but it also strengthens the case for the Federal Reserve to continue increasing interest rates, which could trigger a decline in stocks.

Still, these points aren't what really have me worried. Earnings have a way of beating expectations and interest rates are still extremely low.

Instead, I believe overall economic growth could be the final straw.

The first estimate for U.S. fourth-quarter GDP is scheduled to be released on Jan. 29, and the Atlanta Fed GDPNow model is forecasting growth of just 0.8% on a seasonally-adjusted annual basis. That's down from expectations of almost 3% in November, and well below the market's estimate. It would also represent the slowest quarterly growth since 2009.

GDP Chart

Digging deeper, we see some key components look extremely weak. Investment in non-residential structures, a big part of private spending, is expected to have plunged 3.9% in Q4, while residential investment is expected to have dropped 1.9%.

U.S. growth isn't helping support the global economy as it has in the past, and global exports skidded to the second worst year-over-year change since 1958, behind only the 37% drop suffered in 2009.

When the advance estimate for fourth-quarter GDP is released on Jan. 29, I believe the disappointment over what should have been a jolly period for the economy could send the markets into full-blown correction mode.

Buy Insurance Against A Deeper Correction

One of the simplest and best ways to insure your portfolio against a market drop is to buy put options on an index fund like SPDR S&P 500 ETF (NYSE: SPY ) . If the broader market tumbles, these puts should increase in value and help offset any losses in your portfolio.

With SPY trading for $193.66, we can buy the SPY Feb 192 Puts for about $4.35. That is a put option with a $192 strike price that expires on Feb. 19. Each contract controls 100 shares, costing you $435 per contract.

This trade breaks even at $187.65 ($192 strike price minus $4.35 options premium), which is about 3% below the current price.

Let's say SPY drops about 5% to $184 before the February expiration. In this case, the option would be worth at least $8 ($192 strike price minus $184 ETF price) for an 84% return in 38 days. If the market falls even further, our profits will increase.

Of course, if the market turns higher from here, the put options will lose money but we will still hopefully make money on our other investments. We can enter a stop-loss at $2 to protect against a reversal in the market. This means the most we can lose is $200 per contract.

If the market rebounds, I will sell another put option with a later expiration for protection through the summer months.

Using a simple put option strategy on an index fund as portfolio insurance can be an incredibly lucrative strategy. Just ask Jared Levy's Profit Amplifier readers…

They made 62% in nine days with an SPY put option, which works out to an annualized gain of 2,532%. And a put option on a small-cap ETF made them 34% in four days, or 3,080% annualized. If you're interested in trying Jared's next few trades risk free, you can get all the details here .

This article was originally published on ProfitableTrading.com: Warning: This Report Could Trigger a Full-Blown Correction

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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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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