Long-term investors are optimistic about the stock market’s prospects. It makes no difference if the feel-good vibe comes from patriotism, past stock market history, or the rumblings of respected names in the investing world. The bottom line is that their money is still being put to good use.
They know better than to try to time the stock market by predicting when it will top or bottom. They invest for the long term and add to their holdings when the market declines and a buying opportunity arises.
Traders and short-term investors, on the other hand, do not think in this manner. They don’t have the luxury of buying into market losses and they don’t care about where the stocks will trade in a few years.
They just think about whether the market (i.e., the price of their particular investment) will rise or fall in the near future (perhaps 1–3 days to two weeks). As a result, they don’t consider “buying the dip” as an investment strategy unless one of their technical indicators gives them a clear buy signal.
When the Market is Falling
Rather than explaining the exact circumstance that exists with a specific falling stock market, consider every time the market falls after a significant rally. Assume that you acknowledge that you are unable to forecast the future and that you are unsure if current circumstances represent:
- The start of a bear market.
2. The beginning of a very brief crash
3. After a healthy correction, another rally to new market highs is expected.
4. The beginning of a time of market stagnation in which most investors would lose money.
- Borrowing capital to spend is not a smart idea. Don’t spend money that you’ll use in the next six months on anything else. Just spend money that has been set aside for that reason.
- Learn how to trade options to secure your portfolio from a costly loss while remaining bullish at the same time. (For more information, see below.)
Portfolio-protecting option strategies are available for long-term bullish investors. These strategies are appropriate for investors who:
- Are willing to pay for insurance — They know that if the market turns around and rallies, some of their future gains will be sacrificed because they purchased portfolio security and peace of mind. This is standard practise in any insurance scheme. For example, it could be a waste of money to purchase insurance if your home has never been burned down, but if it does, you cannot afford to be without it. Consider investing in the stock market in the same way.
- Want protection. To put it another way, prudence dictates that it might be time to hedge your portfolio by reducing exposure to a significant downturn, but you still want to be invested in case the market turns around..
In-the-Money Call Options may be used to replace stock.
For example, you own 300 shares of XYZ, which are currently trading at about $58 per share. Follow these steps:
- Sell the stock to withdraw the funds from the market.
- Purchase three call options right away (do not wait for a “better time”). The strike price must be profitable. In this case, you should possibly purchase the 55-strike call. However, if you’re willing to take on more downside risk, the 50-strike call is still a viable option.
- Select an expiration date that best suits your requirements. The longer the expiration date, the more you’ll have to pay for the call option. A later expiration date, on the other hand, provides portfolio security over a longer period of time.
Let’s pretend that XYZ dropped to $48. Obviously, stock can be purchased for $48. Alternatively, you can continue the safety-first approach by purchasing three new call options struck at (i.e., the strike price is) $45, while selling the old calls if there are any bids for them. You just lost the cost of the cost call option because the stock dropped from $58 to $48. Other shareholders suffered a $10 loss per share.
You still have complete ownership of 300 shares of XYZ if the market downturn ends and the market bounces. You get to indulge in the stock market rally no matter how high it rises. The only loss (the possible benefit you missed out on) is the call option’s time premium.
The intrinsic value of that call is $3 ($58 stock price minus $55 strike price) and the time value is $2 if you paid $5 for it. You will have missed out on the additional $2 per share, but you will have been covered from a huge loss and will have been a part of the rally. It could be a fantastic deal.
Buying put options (and holding the stock) is an alternate strategy, but it is not recommended for inexperienced traders because it is much easier to understand exactly what they own when the position is long call options. Having a mix of stock and put options can lead to uncertainty, which is something to avoid.
However, this approach is intelligent portfolio management, and it’s something you can learn about — even if you don’t plan to use it right now.
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