Last Thursday (May 6, 2010), the market dropped nearly 1,000 points during the day as investors rushed to unload stocks. Fear and panic were all over the airwaves as commentators tried to find a way to explain the precipitous drop.
Although the stock market crash was terrible for some, it presented opportunities to others. Here are a few strategies that you can use next time to survive a stock market crash:
Buy put options.
Put options are a form of protection against a drop in price. They limit your downside risk by giving the buyer the option to sell their shares at the strike price. For example, let’s say you bought 100 shares of US Steel at $55. Your total cost would be $5,500 plus brokerage fees. You decide to protect yourself in case the stock drops so you buy one put contract (one put contract = 100 shares) with a strike price of $50. The options contract cost you $5 per share for a total cost of $500 ($5 x 100 shares). If US Steel drops below $50 during the option period then you would exercise the option and limit your losses. You can also purchase put options to sell shares of stock that you don’t own. This is done by traders who speculate on individual stock price drops.
Sell call options on the cheap.
You can also make yourself some extra cash by writing call options.
A call writer collects a premium by selling a call option to buyers who have the right to buy shares at the strike price. When you sell a call option, you are obligated to sell shares to the buyer. Selling a call option is a bet that a stock will go down.
For example, let’s say you sold one call contract of Best Buy with a strike price of $50. The current market price of Best Buy is $41. You get paid a premium of $900 (nine shares x 100 shares). If shares of Best Buy stay below $50 for the option period, the option will likely expire without the buyer executing the contract. You would get to keep your $900 profit. If Best Buy’s price rose above $50 however, the buyer would exercise the contract and the call writer would be forced to sell the buyer shares at the $50 strike price.
Just be careful; losses can be substantial when writing calls. Losses are only limited by how high the stock’s current price rises.
Buy shares of companies that have been beaten down.
Most people do the exact opposite of what they are supposed to do when investing. They buy high and sell low. They buy shares when stocks are going higher and sell shares when stocks are going lower. As a stock price rises, investors often feel as if they are missing out and will buy shares of a company regardless of the valuation. This is known as chasing a stock. Conversely, when a stock is falling investors will often dump shares because they are often afraid that the stock will keep dropping to zero. The best thing to do is often the opposite of what you are feeling. Keep a list of stocks that you would like to buy and the price that you are willing to pay for each company. Market dips will present you with an opportunity to buy a great company on sale!
Take a walk.
You would think that the world is ending if you are watching financial television when the Dow is tanking. Analysts are all over television advising you to buy or sell shares. One of the best things to do when the market is down is to turn off the television.
Financial television programs are concerned with short term market movements and momentum trading. This does not help the long term investor. You never want to make buy or sell decisions out of emotion. Emotion has no place in investing. Your decisions should always be made when you are thinking clearly. So, go for a walk or take a bike ride. Relax and check back in on the market when fear has subsided.
What did you do on last Thursday when the market was crashing? Let us know in a comment!