How To Profit From A Stock Market Crash, Part I: Protect Investment Capital

by: Epsilon

Some are calling the rally we have seen since the start of 2012 a bear trap, an insignificant bounce that will soon lose momentum and drive our markets down further. Extreme skeptics are even predicting that we will see a stock market crash in 2012 similar to that of 1929. Do I believe it? Not really, but I'm prepared for the worst, and you should be too.

The success of great investors generally isn't due to an ability to predict market movements with 100% accuracy. Rather, their success is generally attributed to preparation; having a plan for any market condition. This series will outline some simple strategies that will help you prepare as the great investors do: First, by protecting investment capital, then by making money in the event of a significant bear market.

Protecting investment capital should always be first priority when investing, especially in potentially tumultuous markets. August, 2011 taught us this lesson once again. Many unprepared investors saw their portfolios fall 10%, 20%, or more within a just a few days. The prepared investor, however, was likely stopped out of his position within the first 5% of the fall, saving himself from the significant loss felt by many others.

Being "stopped out" refers to using stop loss orders or trailing stop loss orders, two very handy tools that equities investors use to protect their investment capital. Stop loss orders limit the investor's risk by giving him the advantage of placing an order that will automatically sell his position if and when it falls to or below a specified price. For example, if an investor purchases stock XYZ at $20.00 he may wish to set a stop loss at $19.00 to limit his loss if the position moves against him. More information on stop loss orders can be found here.

Trailing stop loss orders are similar to traditional stop loss orders but add one handy feature. Instead of choosing a baseline price to protect from loss, the trailing stop loss order allows the investor the ability to limit his potential loss by setting a stop loss order that "trails" the stock as it moves upward. For example, if an investor purchases stock XYZ at $20.00, instead of placing a stop loss order at $19.00 he may wish to place a trailing stop loss order at, let's say, 7%. With this order in place the stop loss point will always be 7% below the highest price of the stock as it moves upward. As they say, "let your profits run". Trailing stop loss orders allow the investor to do just that; all while keeping a tight grip on those profits without the need to actively monitor his position. More information on trailing stop loss orders can be found here.

In summary, when investing, sometimes the best offense is a strong defense. Stop loss orders are just that, a very strong defense that should be used by equities investors to protect from significant loss of capital. After all, where would you be without your investment capital?

Next we will look at some strategies for reinvesting this capital and ways to profit from a bear market.

Continue to Part II

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.