The October 2011 gains in the stock market have been nothing short of epic, and it's a performance that we haven't seen since 1974. With August of 1932 seeing an incredible 39% gain, October's 10.77% gain doesn't seem quite as impressive, but if you've followed your portfolio balance, you're undoubtedly very happy with what you see. TUTORIAL: Investing 101
Not all of the October statistics are cause for blind jubilation. Of S&P stocks, 82% are in the overbought territory, and according to Bespoke Investment Group, these overbought conditions often lead to a stock market correction that returns the market to a better balance of supply and demand. Does that mean there is a cause for concern? Maybe, but there are ways to protect your October gains. This article will examine ways we measure and manage risk. (For more, see Measuring And Managing Investment Risk.)
The easiest, and most effective, way to protect your gains is to sell some of your positions. One strategy is to sell an amount equal to your gains, and leave the original amount in the market to profit from further upside.
Professional money managers protect themselves against loss by purchasing put options against their stock positions. If you have a stock position that is valued at $38 per share, you could purchase one put option per 100 shares, you own, with a strike price of $35. If the stock were to drop below $35, you won't suffer any losses below your strike price.
Write a Covered Call
Similar to a put option, if you own at least 100 shares, you can write a covered call at a strike price above the current price of the stock. Not only do you collect the premium, paid by the seller, if the stock price drops, the value of the call option drops as well. You can buy it back at a lower price, which produces a profit for you. If the stock continues to rise, you may have to sell your covered call at a loss.
Don't Change Your Strategy
Prior to October, your portfolio was probably highly defensive given the volatile nature of the markets. Your portfolio should remain defensive until there is further evidence that the correction will continue. It's ok to allocate a small additional percentage to growth stocks, but an all-in bull market approach remains ill advised.
Don't Trust Europe
Although October saw positive steps forward in the European debt crisis, as we've seen numerous times, over the past year, the situation can turn negative rapidly, as seen with today's announcement of the Greek referendum. There are plenty of good stocks to choose from, so committing money to banks, or other stocks, that have a lot of European exposure is unnecessary.
Don't Get Greedy
The financial media would have you believe that the mark of a successful investor is to match the gains of the S&P 500. A prudent long-term investor will have a mix of stocks, bonds and other products. Each of these asset classes will have different degrees of volatility. When averaged together, your portfolio's overall performance will not equal the S&P 500, and aren't you glad? When the S&P saw double digit losses, in less than a month, your balanced portfolio outperformed the index.
The Bottom Line
The impressive October gains won't seem impressive if you give all of the gains back. If you're a trader with a short-term horizon, now may be the time to take some of the profits. If you're a longer-term investor, consider using your gains to rebalance your portfolio by weighting a little heavier in equities. As a long-term investor, you shouldn't panic when your investments experience short-term movements. (For more, see 10 Tips For The Successful Long-Term Investor.)