So, you think the market has had a big run, is ripe for a correction, and that the six months starting now are usually a rocky time for stocks. What should you do? "Sell in May and go away" isn't about timing or outguessing the market -- a fool's errand if there ever was one. It's really about limiting risk.
According to the Stock Trader’'s Almanac, from 1950 to 2011 the Dow Jones Industrial Average gained on average 7.5% over the six months from November through April, but only 0.3% from May through October. And the S&P 500 fell 10% from its April peak last year, 19% in 2011, and 16% in 2010. That's a tiny statistical sample, but it shows that late spring and summer can be rough on your portfolio.
Most investors would be perfectly OK just holding on and heading for the beach. But if you're more active and want to protect some of your gains, there are some sensible, conservative strategies you can use to hedge against a market correction. There also are some pretty bad ones, which I'll get to later.
1. Rebalance twice a year. Instead of rebalancing in January, you can use the calendar to your advantage and buy or sell to reach your target allocations on May Day and Halloween. Let's say your target stock allocation is 50% of your portfolio, and the market's gains have pushed equities to 55% of your assets. Well, just exchange that excess 5% in stocks into short-term bonds and cash now, and adjust it again on Oct. 31, if necessary.
2. Lock in some gains. If particular stocks or ETFs you hold have posted huge advances over the past few months, why not put some of your profits in the bank? I'm not suggesting selling all your big winners -- that's often a very bad idea. But selling, say, 10% to 20% of your position in a stock or ETF that has had a great run is a prudent way to protect against sudden corrections.
3. Lighten up on your losers. The market's big move has pushed a lot of stocks higher, but you still may be underwater on some. If this is the best they can do, maybe now is the time to put them out of their misery. That will lower your equity exposure while concentrating it in stronger stocks and sectors.
4. Set trailing stop-losses. Let's say you have some winners but you want to let them run. Set a percentage below the current price of a stock or ETF -- say, 10%. As the stock moves up, the price at which a sale is triggered will rise with it. Stop-loss orders are free until a sale is actually executed, and then you pay commissions. But use stop losses only for the shares you want to sell.
5. Use simple options strategies to hedge your stock holdings. This strategy is not for everyone; options can be a complex game. But some simple hedging strategies can give you protection at a relatively modest cost. Ryan Detrick, senior technical strategist at options specialist Schaeffer's Investment Research in Cincinnati, suggested a couple of simple ones. First, he told me, Treasury bonds tend to zig when stocks zag. (Statisticians call it "negative correlation.") You don't have to love Treasuries for the long haul -- I certainly don't -- to use short- to medium-term options to hedge your stock holdings.
Detrick likes call options on the iShares Barclays 20+ Year Treasury Bond ETF (TLT). The ETF closed at about $123 on Tuesday, so buying call options expiring in September or December 2013 with a $127 or $128 strike price will give you some protection against a big stock correction. You could also buy put options on the SPDR S&P 500 ETF (SPY). The value of put options rises when the underlying security falls, so buying September or December puts with strike prices of $140 or lower will protect you from an unexpectedly sharp correction.
Detrick says you shouldn't buy options worth more than 1% to 2% of your equity holdings. Options benefit from huge leverage if the market goes their way -- which cushions your stock holdings against big paper losses -- but they can also expire worthless if stocks rise. "It's almost like life insurance," he said. "You hope you don't have to use it."
There are also some things you shouldn't do. Don’t sell everything, go into cash, and buy it all back in October. You could miss a big rally in an exceptional year and wind up buying back in at a higher price. And avoid some of the more exotic ETFs people have been using, theoretically to hedge their risk, but actually to speculate. A couple of years ago, I wrote that leveraged ETFs were the worst investment ever, and since then many investors have had their heads handed to them in these truly horrific vehicles. I would avoid them like the plague as hedges against a spring stock swoon. I'd also run like the dickens from the volatility-linked exchange traded notes (ETNs) some foolish people have used to speculate on rises in volatility that never came. One of them, iPath S&P 500 VIX ST Futures (VXX), lost 94% of its value over the past three years as of Dec. 31.
Of course, we may not see a correction at all. With the Federal Reserve buying $85 billion of bonds a month, the Bank of Japan opening the spigots, and the European Central Bank cutting rates by 0.25%, there's plenty of liquidity to boost stocks in coming months. But if you're watching the calendar nervously and want to keep some of what you've made in this bull market, a little bit of seasonal hedging could go a long way.