Daily Gains Letter

How to Protect Your Investments from a Market Correction

By Sasha Cekerevac for Daily Gains Letter |

DL_Sasha_060213A common worry for many investors is what happens to their assets during a market correction. This is a well-founded worry, but there is an investment strategy that one could add to help protect assets during a market correction.

Options can be utilized as part of an overall investment strategy to help reduce total portfolio risk. When a market correction occurs, adding products that go up in value during this event can help mitigate downside losses of the portfolio.

While option trading is complicated, I will briefly outline the basics of this investment strategy that can help insulate against a market correction. There are two types of options, calls and puts. Simply stated, a call is an option to buy an underlying asset at a future point in time and a put is an option to sell an underlying asset at a future point in time.

One can buy and sell both calls and puts, creating quite a complicated investment strategy. However, for the purposes of protecting against a market correction, if volatility is relatively low, as is the case during most bull markets, buying puts helps protect one’s portfolio.

Clearly someone interested in trading options should educate themselves further before embarking on this investment strategy. They should not, however, be deterred, as the advantages of adding this component far outweigh the time and energy spent in learning about this category of investments.

One phenomenon that helps basic option protection against a market correction is that volatility usually goes down as the stock market moves up. This is because the stock market moves up at a much slower pace than when it goes down. You might hear of a market crash, yet no one thinks of a market crashing up, only down.

This characterization of the differences in market movements doesn’t occur for all asset classes, just primarily equities. Commodities can have outsized moves both up and down, but equities tend to creep up slowly and move down violently.

This violent behavior when a market correction occurs is why it’s beneficial to have options that go up in value during this time, adding an important component to a sound, long-term investment strategy.

There is a lot of information regarding option trading, both online and through books, and one should spend quite a lot of time educating one’s self prior to making any investment. Having said that, alleviating some of the concerns regarding a market correction can help reduce risk and possibly increase total returns to an investment strategy.

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