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How to Protect Profits and
Make Money in a Bear Market:
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by
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Dr. Bart A. DiLiddo
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"So how does one protect profits and
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make money when the big, bad Bear arrives?"
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| Historically stock prices go up. Indeed, over the long-term, they go up an average of nine percent per year (assuming reinvested dividends). At this rate of appreciation, individuals can turn small investments into a substantial fortune. Clearly, stocks are one of the best investments an |
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| individual can make. They offer the opportunity to participate in the growth and wealth of America. Buying stocks is fun. It's an event filled with high hopes and anticipation. Selling, however, is very difficult. Selling represents the end of the investment transaction. Paper gains or losses and tax |
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| consequences become reality. Most investors tend to avoid these events. So how does one protect profits and make money when the big, bad Bear arrives? Several defensive tactics can be employed. First, let's discuss the issue of protection profits: |
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| A. Restrict losses of capital appreciation, and |
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| A. Restricting Losses |
| The simplest and most direct way of restricting losses of capital appreciation is to use Stop-Sell prices. This discipline requires that one determine ahead of time the price at which they will sell a stock. How one does this depends upon their particular circumstances. However, VectorVest can help. VectorVest gives weekly updated Stop-Prices for every stock it covers. VectorVest uses a combination of moving averages, volatility and VST values to compute Stop-Prices. These Stop-Sell Prices may be used as Stop-Sell prices on long positions, or as Stop-Buy prices on short positions. In the VectorVest system, any stock whose current price is below the Stop-Price receives an "S" recommendation. This eliminates any confusion or contradiction between the VectorVest Stop-Sell Price and VectorVest recommendation.
By using the VectorVest Stock Advisory, you will know your selling price from the day you buy a stock until the day you finally sell it. The risks in using Stop-Sell Prices are those of high portfolio turnover and of being whipsawed. For example, a stock may fall below the Stop-Sell Price just briefly; then head upward again. Your Stop order may have taken you out of a stock you really liked. If you decided to get back into the stock on the upswing, you would have been whipsawed. This would have cost you a few points on the stock and round-trip commission costs. To reduce these problems, place Stop-Sell orders at prices just below a whole number. Say 29 7/8 instead of 30 or 30 1/4. Another tip (especially with OTC stocks) is to avoid intra-day volatility. Make your decisions to sell based upon closing prices. If for some reason (tax consequences for example) you do not want to sell a stock, you may restrict losses by "Selling against the Box."
In this relatively obscure technique, you do not sell the stock you own. You ask your broker to borrow the same number of shares of the stock you own and sell them for you. In this fashion, you have frozen your position. You still own your stock, but you have also sold short an equal number of shares of borrowed stock. So the stock's price is totally counterbalanced by the long and short positions. The only thing this technique really does for you is to provide time. It allows you to eventually sell a stock when it is to your advantage. If you do not intend to sell XYZ under any circumstances, do not sell against the box. Use hedge tactics.
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| B. Hedging Against Losses: |
There are at least three hedge strategies
to protect profits in a Bear market. Put options provide the simplest, most direct and certain method of hedging against falling stock prices. A Put option is like an insurance policy. In the event disaster strikes in the form of lower stock prices, Put options become increasingly valuable. Therefore, they provide profit gains, which directly offset losses. In the event stock prices don't go down, Put options become worthless. But they have provided protection (at a cost) for a specified period of time. A Put option gives you the right to sell a stock at a given price for a given period of time. For example, on September 27, 1990 Exxon stock traded at 49 3/4. Therefore, you could have bought an Exxon January 50 Put for 2 1/4 ($225) plus commission. This Put option gives the owner the right to sell 100 shares of Exxon at 50 $/share until the close of trading on the third Friday in January 1991.
This may sound like fairly expensive insurance, but it could be very cheap compared to experiencing a large drop in the price of your stock. It's worth noting that Put options of more volatile stocks will cost much more on a percentage basis than those of relatively stable stocks such as Exxon. To achieve downside protection, one does not necessarily have to buy one-on-one Put options for each and every stock in their portfolio. One may buy Index Put options, which reflect hedges against overall market price drops.
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| This approach may or may not provide the desired protection one seeks depending upon the performance of the market vis-a-vis one's portfolio. In any event, the risk associated with buying Put options is limited to the cost of the option. Selling covered Call options provides an alternative to buying Put options. This tactic simply involves writing (selling) a Call option on a stock that you own. One Call option covers 100 shares of stock. Selling covered Call options is somewhat different than buying Put options. It has the advantage that someone is paying money to you for the right to buy your stock at a specific price for a given period of time. Major disadvantages are that they provide only limited downside protection, and your stock may be called. If the price of the stock goes down (or does not go up) and time runs out, the option becomes worthless. Then the money you received is all yours. You can use it to buffer the downturn in the price of your stock. However, if the stock goes up in price, you have two alternatives: |
a. You can buy back the Call option at a higher price than you paid for it. Recognizing, of course, that the price of your stock also went up, or
b. You can let your stock be called at the price you sold the option for. In this case, you would have failed in your objective of not selling your stock. But you would have made some money on the option provided commissions didn't eat up all the gains.
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| An example of selling covered Calls is currently in our VSA Cash Account. On September 7, 1990, we bought 100 shares of Betz Labs at 38. A week later we sold 1 Jan 40 Call for 1 7/16. After commissions, we received $109 to use as a buffer against a price drop. Do not assume that selling Index Call options against your portfolio is the same as selling stock specific covered Calls. The market may behave quite differently than your specific stocks. A third approach to hedging profits is to sell stocks short. Selling stocks short is like looking at the world in reverse. You expect these stocks to go down in price, not up. The aim of this tactic is to create a "short account" by selling stocks you don't own (your broker can arrange this by borrowing stocks) in the hope that they will go down in price as fast or faster than the stocks in your "long account." In this fashion, any loss in your long account will be compensated by gains in your short account. Hedging by selling short is the wave of the future. The beauty of short selling is that you can spot the stocks that will go down even in an up market. When the market goes down, these "dogs" tend to go down even faster than the market. Therefore, selling short offers the opportunity of increasing your performance margin in an up market, and actually making money in a Bear market. |
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| How to Make Money in a Bear Market: |
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| Just imagine for a moment that you were not preconditioned to betting on the market going up, that you were conditioned to believe that a down market offered as much opportunity for capital appreciation as an up market. What would you do? Go with the flow. If the market were heading down for whatever reason, you'd take advantage of it. SELL STOCKS SHORT. VectorVest can help you. While the VectorVest system of assessing Value, Safety, and Timing was designed to spot stocks which are most likely to go up in price, it also spots those which are most likely to go down. VectorVest is unique in that it provides an estimate of value for each stock it covers. If a stock is substantially overpriced, it is highly likely that a downward price correction will occur. Most investors don't understand the first thing about quantitative valuation of stocks. They sense it qualitatively, and listen to stories of great expectations. Worthless stocks are often driven up to ridiculous prices. That's when you jump in and Sell-Short. Look for stocks with low Relative Value (RV) and low Relative Safety (RS) values. When Relative Timing (RT) starts heading south, you've got a hot prospect. The Special Report, The Bottom 50 Stocks Over $5 Per Share Ranked by VST Vector on page 9 of the Advisory was created to highlight our favorite candidates for short selling. Although selling short is like looking at the world in reverse, the same rules of prudent investing apply. Diversify, don't plunge into the market, and use Stop-Buy Prices. Spread your risk. Do not put more that 5% of your money into any single short position. Remember that stocks can go down only so much. They can go up forever. Be especially alert to diversifying and to covering your short positions when the price starts to go up. |
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| When the RT value of a shorted stock approaches 1.00, get ready to buy it back (cover it). When the REC goes from "S" to "H," cover it for sure. At the same time, be prepared to live with enormous percentage swings in price. A three-dollar stock may go up 1/2 point in a single day. That's over 15%. Can you handle it? Yes you can if you watch RT values, and use Stop-Buy prices to cover. You won't win every time, but you can control losses. These techniques are being illustrated each week in our VSA Cash Account. This account is doing extremely well. It was over 80% hedged when the Bear came, and is mainly short while he's around. Another way to make enormous amounts of money in Bear markets is to simply buy Put options. Selling naked Put or Call options is not a strategy advocated by VectorVest. It's terribly risky. Use options as a conservative method (buying Puts, selling covered Calls) of making great profits in a Bear market. There's no need to sit around and suffer when the Bear comes to dinner. Leave that to the Mutual Fund managers who cannot use most of the techniques discussed here. You, as an individual investor, are free to protect profits and make money in a Bear market once you know how. |
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| Use Stop-Sell Prices
Buy Put Options
Sell Covered Call Options
Hedge Your Portfolio by Selling Stocks Short
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