A stock market correction is a 10% decline in the price of an individual stock or index from its 52-week high.
The stock market is always rising and falling, which means that sometimes share prices will experience gains even if the company’s book value hasn’t changed. These fluctuations are largely due to the psychology of investors and speculators, who anticipate that the stock or index will help them turn a profit, even if revenues or sales don’t back up the valuation. And as more and more people jump on the bandwagon, the price is inflated.
Once a certain price is reached, the stock or index starts to become considered overvalued. At this point, an event will occur that causes the trend to reverse and market participants will start to close their positions to realize any gains. This causes the price to decrease and reach a more stable price – at this point, the market is said to have ‘corrected’ itself.
Market corrections usually take into account a stock or index’s true value. It is not necessarily that the company is losing value in the real world, so much as the share price is correcting to reflect the stock’s actual value on paper.
Common Portfolio Protection Strategies
- Diversification
One of the cornerstones of Modern Portfolio Theory (MPT) is diversification. In a market downturn, MPT disciples believe a well-diversified portfolio will outperform a concentrated one. Investors create deeper and more broadly diversified portfolios by owning a large number of investments in more than one asset class, thus reducing unsystematic risk. This is the risk that comes with investing in a particular company as opposed to systematic risk, which is the risk associated with investing in the markets generally.
- Non-Correlating Assets
Stock portfolios that include 12, 18 or even 30 stocks can eliminate most, if not all, unsystematic risk, according to some financial experts.
Unfortunately, systematic risk is always present. However, by adding non-correlating asset classes such as bonds, commodities, currencies and real estate to a group of stocks, the end-result is often lower volatility and reduced systematic risk due to the fact that non-correlating assets react differently to changes in the markets compared to stocks. When one asset is down, another is up.
Ultimately, the use of non-correlating assets eliminates the highs and lows in performance, providing more balanced returns. At least that’s the theory. In recent years, however, evidence suggests that assets that were once non-correlating now mimic each other, thereby reducing the strategy’s effectiveness.
- Stop Losses
Stop losses protect against falling share prices. Hard stops involve triggering the sale of a stock at a fixed price that doesn’t change. For example, when you buy Company A’s stock for $10 per share with a hard stop of $8, the stock is automatically sold if the price drops to $8.
A trailing stop is different in that it moves with the stock price and can be set in terms of dollars or percentages. Using the previous example, let’s suppose you set a trailing stop of 10%. If the stock goes up $2, the trailing stop will move from the original $9 to $10.80. If the stock then drops to $10.50, using a hard stop of $9, you will still own the stock. In the case of the trailing stop, your shares will be sold at $10.80. What happens next determines which is more advantageous. If the stock price then drops to $9 from $10.50, the trailing stop is the winner. However, if it moves up to $15, the hard stop is the better call.
Proponents of stop losses believe that they protect you from rapidly changing markets. Opponents suggest that both hard and trailing stops make temporary losses permanent. It’s for this reason that stops of any kind need to be well planned
- Share CFDs
CFDs offer a flexible alternative to traditional investing and are therefore an attractive instrument for a wide variety of traders. New investors can trade CFDs successfully but you should undertake research and gain a thorough understanding of the benefits and risks involved before putting real money at risk. With the right preparation traders can take full advantage of the various positives that CFDs offer while limiting the potential downsides.
WHY SHARE CFDs CAN BE USED TO PROTECT YOUR PORTFOLIO FROM A CORRECTION IN STOCK MARKET
The ability to achieve gains in bull and bear markets
One clear advantage of CFD trading is that traders are not limited to establishing positions in only one type of economic environment (for example, posting buy positions in a bull market). The ability to trade in both rising and falling markets adds flexibility to your CFD trading strategy and allows you to forecast price movements that coincide with the underlying fundamentals (which can fluctuate in both positive and negative directions).
The ability to hedge positions
One method that investors use to limit potential risk is the implementation of ‘hedged’ positions. For example, if you have a long position on a stock that is accruing losses, you can open a position in the opposite position using a short CFD. This might seem redundant to some, but it will help to balance losses, as the short position will start to make gains if prices continue in a downward direction. This balance, or ‘hedge’, will thus allow you to limit risk and prevent future losses.
Flexible contract sizes
Many CFD brokers have a variety of trade sizes available which can be used for various trading styles or types of investment account. It is generally recommended that newer traders use smaller lot sizes until they have developed a successful trading strategy that makes gains over time. More experienced investors can choose to put more money at risk so that they do not feel limited in the way their trades are structured.
