Invest With Caution After a Rally

As of this writing, the U.S. stock market indices have risen nearly 70% since they bottomed in March of 2009. (The Dow Jones Industrial Average recently topped 11,000 – a little over a year after it bottomed at 6,547 on March 9, 2009.)

It has been an incredible move up. The rally has given many investors some much-needed confidence after getting slaughtered in the fall of 2008 and the beginning of 2009. But as it always is with investing, the most important question is not what happened in the past, but what will happen moving forward. How should you approach the stock market after such a large move higher?

Market Timing?

Many investors think that there are only two approaches to investing: market timing or passive investing. Market timing or trading the market means actively moving in and out of positions attempting to take advantage of short term trends and movements. Passive investing typically means to deploy money into stocks at set intervals no matter what the market is doing or has done recently.

I do not believe that most investors should attempt to time the market by trading on short-term trends and movements. That said, should passive investors completely ignore what is happening in the market? Should we really blindly continue to buy stocks no matter how high the market goes? I completely disagree with such a philosophy.

Taking Profits Is Never Wrong

With such a significant move higher in stocks in an extremely short period of time, I strongly believe that taking profits in certain positions is a wise move. Now, this does not mean you should unload your entire stock portfolio. Maybe it means unloading a third of your position, and leaving the remaining two thirds as is in case the market goes higher.

Another approach might be to simply halt buying or halt the deployment of new money into the market. If you don’t want to sell any of your positions because you believe the market will go higher, then maybe you wish to accumulate some cash for a few months instead of purchasing more shares of your favorite stocks? If a correction occurs, then you will have some cash ready to deploy into positions at more attractive entry points.

The risk, of course, is that the market continues to blast higher, and you’re left with cash earning a measly return. Is that really such a bad scenario? After all, you are still holding stocks and are still making additional money as the market rises. As I said before, the ultimate goal is to preserve our money and protect against loss. As the market screams higher, the risk for loss goes higher. I prefer to mitigate such a risk.

An Advanced Strategy For Downside Protection

More seasoned investors might look to the world of options for protection against a potential correction in the stock market. There are ways to conservatively use options on positions that you hold in your portfolio that can help protect you if your stocks move lower.

One of my favorite strategies is to write “covered calls” on my positions. By selling a call option on a stock that I currently hold, I’m able to collect a premium in exchange for promising to sell my stock if it hits a certain strike price. If the stock moves lower, my option expires and I keep the premium. The premium offsets some of the loss in share price. The risk on the covered call play is that you might be forced to sell your stock and lose out on additional upside. To sum up such a strategy, we’re giving up potential upside for downside protection. In my opinion, not a bad trade off after a 70% increase in the market.

A second possibility to consider is to purchase put options for the stocks that you own. By purchasing a put option, you obtain the right to sell your stock for the agreed upon strike price. This means that if the stock falls below the strike price, you are able to sell the stock for higher than the market price. In exchange for the downside protection, you agree to pay a premium. Therefore, your risk is limited to the amount paid (the premium) for the put option.

Option strategies definitely can be wise in certain situations; however, most investors do not have experience trading options. As such, caution should be exercised in implementing any of these strategies. Trading options requires plenty of research and study. (Not surprisingly, the Internet isn’t lacking in resources that can help new investors learn how to trade options.)

Conclusion

No matter what investing or trading strategy you might utilize, it is important that your number one goal be to protect your money against potential loss. A stock market that has already booked a significant run up may or may not have a correction in the near future. Nobody knows exactly what will happen, but the goal is to protect oneself in the case that what happens isn’t that good.

Securing a profit in a position means that you have that money and you cannot lose it. This is always a good thing. Take some time today and look over your portfolio. You may have some investments that have doubled in price over the last year. It might be a good opportunity to scale back such positions. Remember, investing in the stock market is a risky game! Playing it safe is always a smart approach.

For more of Kevin’s writing, visit personal finance blog 20smoney.com.