These sugestions are designed for investing in solid companies and will probably blow up in your face if you try to use them with horrible, dead, dying, penny, or companies with sub-$10 stocks.
Lets say you want to invest in IBM. You've done your homework and like the stock, you have decided on the total amount you want to invest in it (say $10,000), but you are not familiar with how the stock moves in the stock market. What do you do?
Buy one share of it. No really, I mean it. Buy one share. Ok, well, maybe buy a few shares, but not too many :-).. Put it in your portfolio. Start tracking it. Don't do anything else with IBM for at least a few months. Just watch it on a daily basis.
You never want to purchase your entire position in one shot. Instead you want to scale into a position, but in order to do that you need to have some comfort level with how the stock behaves in the market. You don't want to buy at a high price only to see it go down! To determine your entry point can take a few weeks of studying, looking at historical charts, and so forth. Then WAIT for the stock to drop to a point where you would be comfortable buying a substantial amount of it.
Now the day has arrived. You want to make a real purchase. There are three ways you can build your position. You can either scale into it in small chunks over time, say $2000 purchases, or you can purchase much larger chunks (say $5000) and write bearish, near-month covered calls on 75% of the purchase, or you can do the call method but also overbuild your position, then reduce later on at a profit. The latter two mechanisms only work if you intend to make a subtantial investment in the security as covered calls trade in 'contracts' where each contract represents 100 shares of the stock. So using the covered-call methodology means buying a chunk of 300 shares at a minimum.
Method #1 - The small-chunk method is very simple. Start by buying a small chunk. In coming weeks and months only buy similar small chunks when the market is down that day. Don't buy if the market is going up. As the price falls below your entry point you buy larger chunks, say $2500 or $3000. As the price rises above your entry point you either stop buying chunks or you buy smaller chunks, say $1000. Again, only buy on days where the stock is falling. You really want to try to spread out the purchases so the entire position ($10K in our example) is not completely built for several months.
Method #2 - The covered-call method is slightly more complex, and only works well for substantial investments. You buy a large chunk at your entry point. Lets say the stock is priced at 16 and you want to build a $10,000 position. You purchase a large $5K chunk, which is 300 shares in our example, and you immediately write 2 bearish, near-month covered call contracts. For example, you might write 2 contracts with a strike price of 14. This gives you 10-15% of down-side protection. If the 200 shares of stock gets called you will pocket a small profit and be scaled into the position by 100 shares. If the stock does not get called (i.e. it went down substantially) then you are scaled in by 300 shares and take a smaller loss then you would have had you not sold the calls.
This may seem counter-intuitive, but generally the idea when scaling into a position is to try to 'catch the bottom', which for the most part means purchasing shares as the stock goes down, not as it goes up. If you do it right you see RED for a little bit but then the stock hits bottom and starts rising again. The idea with the covered calls is to try to get closer to the bottom. So if the stock isn't going down the investment thesis is broken and you want to get called so you scale-in less. You can then decide whether to leave the 100 shares intact or, if the stock went up, to sell them at a profit, then wait for the next retraction before trying again.
You do not have to choose bearish covered calls, selling at-the-money calls (e.g. stock price $16, strike-price also $16) is also feasible. It increases the chance that you will not get called but decreases the downside protection. Also note that once you've scaled-in the shares, don't write covered calls on them again. The idea is to build a position for a long-hold, not to day-trade.
Method #3 - Over-building the position is something you can do with or without covered calls, but it is considerably safer if you do it with covered calls. The idea here is that you want to make, say, a $10,000 investment for a long-hold, but give yourself some extra wiggle-room to work the market. You build a $15,000 position with the intent to sell 1/3 of it as a trade in the near term, assuming it has appreciated. The intent is to 'park' some of your extra cash in various securities that you are scaling into and thus (theoretically) forming a good basis with. Clearly you only want to sell the extra in those positions that have appreciated above your basis. You would only sell the extra when you need the cash to scale into other securities.
Method #3 is very advanced and requires clear sector diversification in securities that do not correlate with each other (move together with the general market), otherwise ALL the overbuilt positions could end up in the red and you would have nothing to sell.
This is the only use of options that I advocate these days... covered calls only, and for scaling into positions only.
Cash is a two-edged sword. It is something you want to hold during a crash, but not something you want to hold in a sidways or recovering market. Recognizing a crash can come late, which is why proper risk diversification is needed coming into it, so you still have appreciated positions to sell even if you recognize the crash too late. Here's the kicker: The whole point of having had those investments in the first place is so you can build a cash position during or just after the crash and then start reinvesting nearly all of it back into the market. If you do not do this then there was no point having those defensive positions in the first place. If you do not do this then the best you can hope for is to recover back to your original basis years into the recovery. People who are so scared of the market they just hold onto the cash forever may save themselves from the crash, but they will also 'save' themselves from the recovery, missing out on both. I am not saying that the cash should all be reinvested immediately, but I am saying you should be on-track to reinvest it based on your feel for the market.
To an investor who is not afraid of the market being able to build a large cash position during or just after a crash creates a multiplicative opportunity to take advantage of the recovery. Can the market continue to go down as it did in the great depression? It is certainly possible! But if you don't start reinvesting when you think the market has bottomed you aren't likely to reinvest at any other time either. As a simple example of this, lets say the Dow is at 14,000 and half your portfolio is in unleveraged income funds and half is in DIA (Dow tracking ETF). Now the Dow crashes all the way down to 8000. If you were to cash out the still-appreciated income funds and invest them all in DIA your basis in DIA will go from 14,000 to 11,000. If it takes 2 years to recover to 11,000 your portfolio will have recovered its entire pre-crash value. If you did not do anything at all it might take 4 years to recover to the pre-crash value of your portfolio.
In order to be able to reinvest nearly all your cash you need to readjust your portfolio to generate any needed income for an indefinitely-long bear market. This means concentrating more on dividend and distribution-producing securities. They can still be diversified, and in fact diversification is important if you scale-in using Method #3 above, but you do not want to rediversify into cash or cash-like instruments. The whole idea is to reinvest the cash into non-cash instruments! You do not rediversify into cash or cash-like instruments until after the market has significantly recovered.
In fact, having some cash flow is a good idea in general. I recommend turning OFF DRIP (automatic dividend reinvestment). That's right, turn it off. Instead what you want to do is take any extra cash accumulated from all the divvies generated by your portfolio and reinvest them in those portions of your portfolio that have the greatest appreciation potential. In bear markets different sectors will recover at different rates. Reinvesting the divvy in a sector which has mostly recovered is not nearly as good as putting that money in a sector which has not yet recovered.
Remember I am advocating keeping cash at minimal levels until a recovery is well under way. If your portfolio is large enough and you have become fully invested, then hopefully you used Method #3 above and have various over-built positions in different sectors.
Since sectors recover at different paces in a recovery you can take short term capital gains by reducing those over-built positions and moving the capital to other more advantageous positions. Effectively, just sell a little of one position and use the proceeds to add to another position that you already own. Keep track of where the excess capital is and only shift when it is advantageous to do so. Remember that I am not advocating getting rid of positions, that is what day-traders do. If you like a stock you want to keep 100% of your desired position in it intact. But if you overbuilt it to 125%, then by all means reduce down by taking 25% out and move the excess to another position (which then becomes the overbuilt position).
This works best if you maintain several overbuilt positions, where the overbuild represents the capital you would have otherwise invested in cash, money markets, or income funds.
Many stocks but more particularly many index ETFs become range-bound in a sidways market. Two good examples are DIA and SPY. You can take advantage of this to generate a little extra cash for the duration of the bear market but only as long as you take care NOT to screw up your upside potential in a recovery. Always assume that you will not be able to predict when the real recovery is going to happen.
In that respect I recommend that no more then 25% of the portfolio be used for sideways-market strategies.
The easiest strategy is to purchase large chunks of DIA or SPY at various price points once the market appears to be going sideways. For example, a chunk at 79, at 82, and say 85. Keep track of the basis for each chunk. You will see RED as the market is falling and GREEN as the market is rising within the range. When the market rises to, say, 82, write at-the-money covered calls for the chunk you bought at 79. If it does not get called you pocket a maximal premium. If it does get called you pocket (premium + 3) and, this is important, you do not repurchase the chunk until DIA has dropped back down to the original basis, 79 in our example.
With this strategy you are buying chunks on the way down and selling calls on the way up. If the market enters into a real recovery you will end up accumulating a large cash position (because you are not repurchasing chunks that have been called unless the market drops back down to that level), and this is your signal that something has changed in the market. This strategy is auto-exiting and the nice thing about it is you wind up with a hunk of cash with which to execute whatever change in strategy you deem appropriate for the recovering market.
Other strategies involve being more proactive with the positions you currently have overbuilt, possibly shifting them within the sector when two equally good securities (which you already own) start diverging, and possibly writing covered calls on just the overbuilt portion to generate more cash.
One strategy I do NOT recommend is to sell deep in-the-money covered calls. Such calls remove a great deal of risk but also remove all the upside and nearly all the potential profit... for all intents and purposes you might as well put the money in an unleveraged income fund because it will do better.
That is really all I am going to get into. There are many strategies but I really don't want to talk about the ones that might blow up in your face. At least with the DIA/SPY strategy you can just hold it if the market crashes down beyond what you expected, making it equivalent to averaging down the original pre-crash basis.
Discipline is very important when working a bear market. You have to expect to see both RED and GREEN and, generally speaking, you will want to be buying when the market is going down and selling covered calls while it is going up.
When the recovery becomes obvious, because the general market is gone up at least half way between the bottom and the top, you want to think about rediversifying. If you followed the guidelines above then a large portion of that rediversification will be back into income securities and you will have the cash to do it with or the appreciated positions to sell to get the cash to do it with. Rediversify at the same slow rate you used to reinvest earlier. From when the market is half recovered to full recovered you should go from having no income securities to having pre-crash levels of income securities (or whatever is appropriate for diversification purposes).
Doing things this way has the side effect of giving you something to sell if the market crashes again.
You may find it hard to push back into some income-style securities after seeing all the green from the recovery of your equities, but you will thank yourself later if the market is in a false recovery and crashes again. Even if it is a full recovery your income positions will not reach their full pre-crash levels until the equities have fully recovered themselves, and since you invested in them at the bottom their value should be significantly higher then their pre-crash value at that point. Be happy, and stay with the discipline.
If the market has a false recovery re-crashes you should have cash built up from the rediversification, from the Bear-Market strategy I recommended in the previous section, and possibly also from some of the still-appreciated over-built positions. You treat a major retractment just like the original crash, and you probably don't have to make very many adjustments on the way back down.
It is important not to shift back into pure equities (generating no dividend), or at least not do it very quickly. If you don't need the cash flow you may already have pure equity positions, which is fine. But my recommendation is to keep the cash flow up for at least a year and slowly move back into your favorite pure equity stocks during retractments. If you shift back too equickly a false recovery can bite you in the ass and leave you in a very vulnerable situation.
The worst case scenario is we crash, we have a false recovery, and then we crash worse and stay down there. That would be a depression, now, instead of a recession.
During this new drop you should be following the rules above, with the ability to build cash and then reinvest again. A true depression from your standpoint is where you have reinvested all your free cash and the market is still going down.
Your protection during this period, both in a sideways market and in the worst-case scenario, is the fact that the securities you own are now producing sufficient dividends or distributions to cover you cash flow needs regardless of how long the depression is.
If you have chosen good solid securities for your portfolio you will have to wait it out, but keep in mind that what you are waiting for is not a complete recovery, but a recovery to the last point where you had invested on the way down. Once you get back there you will start to have appreciated positions and opportunities to work the market again, and switch back to your bear-market strategy.
Matthew Dillon