The 5 Smartest Responses To The Stock Market Sell-Off

Includes: CBOE, CME, DIA, QQQ, SPY
by: Lou Basenese

According to Barron's Kopin Tan, "The whiff of [interest] rate volatility" is all it took to send stocks reeling last week -- erasing some $775 billion in value in two days. In case you're wondering, that figure is equal to about nine months' worth of Fed bond buying. So my labeling the recent sell-off as an "overreaction" seems apropos. Especially considering that traditional safe havens -- U.S. Treasuries and gold -- got sacked, too. If the economy and market were truly in trouble, those assets would be rallying right now.

So chill, would you? All right. I know that simply telling you to "keep calm and carry on" over and over again won't cut it. As investors, we crave a specific plan of attack for every conceivable market scenario. As I shared yesterday, though, retreating into cash can't be our default setting. It doesn't protect wealth; it destroys it.

So here are five alternative courses of action to consider in the current market. (Yes, it's possible to put the market volatility to work for us.) I'll start with the easiest to implement and progress to a couple of more involved (but opportunistic) strategies.

Volatility Buster No. 1: Trim it Up

Emotional responses always undermine our profitability. We either sell too early, missing out on more profits. Or we sell too late, making it that much harder to recover from our losses. That means in all market conditions, we need to be robotic. Or, more plainly, we need to take emotions out of the equation. The best way to do that, which maximizes profits and simultaneously minimizes losses, is to use trailing stops.

As a general rule of thumb, I use a 25% trailing stop on larger-cap, more liquid investments. For smaller-cap, more speculative investments, I go with a 35% trailing stop. And when fears over a market sell-off materialize, all we have to do is trim up our stops. Doing so keeps us in the market just in case our fears are misplaced, yet preserves our profits at the same time. It's a win-win.

Now, the most common argument against using trailing stops is that market makers can see our orders -- and, in turn, they'll intentionally manipulate prices to stop us out. I'll admit that it does happen. But not frequently enough to swear off using this type of free insurance.

Volatility Buster No. 2: "Put" Your Way to Profits

Buying put options, which gives you the option to sell a stock at a predetermined price, is the closest alternative to using trailing stops. They essentially let you lock in your sale price in advance. And there's nothing a market maker can do to interfere with the strategy.

Keep in mind, though, there's a real cost associated with hedging risk using put options. You have to pay for the option. So if the stock never drops below the strike price (i.e., the stock resumes its rally), you'll be out-of-pocket the cost of the option. As I'm sure you’ll agree, sometimes it's worth paying a little for a lot of peace of mind.

Volatility Buster No. 3: Get Inverted

Dozens of inverse mutual funds and exchange-traded funds (ETFs) now exist that rise when stocks drop. You can purchase these funds in retirement accounts, too. ProShares, Rydex, and Direxion offer the most popular and liquid funds. By taking a small position in any of these funds, you can help smooth out any market volatility. However, if you plan to hold the funds as a form of long-term insurance, just stay away from the double- and triple-leveraged funds.

Volatility Buster No. 4: Bet on the House

We can actually profit from the uncertainty over future interest rates -- and stock market volatility -- by scooping up shares of CME Group (NASDAQ:CME) and CBOE Holdings (NASDAQ:CBOE). The former exclusively handles trading of interest-rate derivatives. So as more and more traders speculate about the next move for interest rates, the company promises to book more profits. As for the latter, it’s the trading venue for options and futures on the VIX Volatility Index (VIX). Again, as traders get more skittish about the next gyrations in the market, they're bound to ramp up their bets on the next move for the VIX.

Since the house always wins, it's best for us to avoid making predictions about interest rates and volatility, and just invest in the companies that promise to benefit from everyone else's wagers.

Volatility Buster No. 5: Buy Value, Not Momentum

During bull markets, many investors get lazy and buy what's working. And they're all too quick to "pay up" for momentum stocks. But guess what? When volatility spikes, high-flying momentum stocks are the first to give back gains. Since I don't believe the bull market is over, we should respond to the market volatility by putting new money to work in undervalued stocks with hidden growth potential. By that I mean companies with separate operating units that are growing at different rates.

Why? Well, sometimes analysts get lazy and only look at consolidated figures. So a company with a division that's growing at a rapid clip -- but happens to own another unit that's flat-lining -- tends to be overlooked (and mispriced). And since earnings continue to climb under the radar, such companies promise to march higher -- even if the multiple expansion for the S&P 500 grinds to a halt.

Sure, finding such opportunities requires more work. But it pays.