How to Protect Yourself from a Stock Market Crash?
With every North, there is a South. With every Summer, there is a Winter. And of course -- with every Upside, there certainly is a Down. So how does one prepare themselves for when the down times hit, and hit hard?
Trailing Stops and How They're Good for You
In the finance world, we use a device called a Trailing Stop. A trailing stop is known as a "stop order" that sells the stock once it reaches a low enough percentage point, due to potential stock risk and volatility - I.e., the amount of uncertainty that comes during the trading period's buy-sell ratio. So what does this mean for you? When the bull markets end and the bear markets begin, alerts are given in order to protect the invested money safely; allowing the money to sit in cash while the market readjusts itself. And as of right now, we are now in the 6th year of our bull market - making it the 3rd longest in US Stock History. This can mean that we're hitting into the late innings of this market and we could be onward for a crash. Of course, it could last much longer. The exact moment the pendulum swings is hard for any average investor to predict, but they all know that eventually it will happen. With that in mind, how does the math work to determine volatility rates to save you money?
Volatility rates are normally comparative to how hot or cold the stock is selling - if the stock is hot, then the volatility's quotient (VQ) will be high, and an inverse for when it's cold. For day traders or fast growth investors, they look for the stocks that will raise up early during the day so that they can receive the biggest bang for their buck. However, this then makes their earnings a burden during tax season. Value investors/advisors that try to stretch earnings to take advantage of cold/lower VQ percentages typically gain higher marginal returns over that period of time. This then turns the gain in the investors favor, rather than disadvantaging them the other way around. Other factors come into play when taking about stock prices compared to the S&P 500 or Dow Jones Industrial Average, but for now - lets look at a trailing stop example so you can get a better idea of how the Trailing Stop works.
Trailing Stop Example
Assume you purchased a stock at $20 per share. Normally, you could place a 15% trailing stop order on it right away to protect your principal from it reaching the VQ% (Volatility Quotient); meaning that if the stock declines to 15% or more, the trailing stop will be triggered, thereby capping your loss rather than it going all the way down with the market.
Now, suppose the stock moves up to $24 over the next few months. While you have enjoyed its appreciation, you are a little concerned that it could retrace its gains to enter a negative figure. Recall that your Good-To-Cancel trailing stop is still in place, so if the stock plunges 15% or more tomorrow, it would still be triggered. Plus, the nice thing with the trailing stop is that if you decide to tighten it 10% to protect as much profit as you can, you are allowed to let the stock run.
Let’s assume the stock moves up further to $25, but then loses favor in the market, achieving a decline of 10% to $23.50. The 10% price drop would trigger your trailing stop, and assuming you were “filled” at $23.50, the gain on your long position would be 35% (i.e. the difference between $20 and $23.50).
If you have any questions about Trailing Stops or Volatility percentages, consult your financial advisor to see what could happen if the Stock Market were to crash tomorrow - because a questioning investing mind is always a smart investing mind.