Buying the Dips

One Idea for Long-Term Investors

Bear-sign.png
Warning: Bear Market Approaching?. From Wikipedia.com

Long-term investors have confidence in the future of the stock market. Whether that feel-good feeling stems from patriotism, past stock-market history, or the rumblings of respected names in the investment world makes little difference The bottom line is that their investment dollars are always at work.

They know better than to try to time the market by guessing when the stock market will reach a top or bottom.

They hold for the long-term and add to their investments when a market decline provides a buying opportunity.

Traders and shorter-term investors do not think that way. They do not have the luxury of buying into market declines because they are not concerned with where the stocks will be trading several years from now. They are only concerned with whether the market (i.e., the price of their specific investment) will rally or decline over the near term (perhaps 1-3 days to two weeks). Thus, the thought of "buying the dip" is not in their repertoire of investment strategies -- unless they get a specific buy signal from one of their technical indicators.

When the Market is Falling

Rather than describing the specific situation that obtains for s specific falling stock market, let's talk about any time that the market is declining after a substantial rally. Assume that you admit that you cannot predict the future and that you do not know whether current conditions represent:

  • The beginning of a bear market.
  • The start of a very short-term crash.
  • A healthy correction to be followed by another rally to new market highs.
  • The start of a stagnant period in which the market will be very boring for most investors.

If you are a typical, confident, long-term investor who does not try to predict what is coming next, and if you have cash being saved for a buying opportunity, then the appropriate strategy is to invest some of that money now and invest even more money -- if and when the market declines further.

There are two major points to consider:

  1. Do not borrow money for investing. Do not use money that will be needed for some other purpose within 6 months. Only use cash that has been designated for investing.
  2. Learn to use options so that you can protect your portfolio from incurring a painful loss and remain bullish at the same time. (See below.)
     

How Options can Help

For long-term bullish investors, portfolio-protecting option strategies are available. Adopting these strategies is a good idea for investors who:

  • Want protection. In other words, prudence dictates that it may be time to hedge your portfolio by reducing exposure to a severe decline, yet you want to remain invested for a market turnaround. 
  • Are willing to pay for insurance. They understand that If the market turns around and rallies, some of their potential profits will be sacrificed because they bought peace of mind and portfolio protection. This is typical of any insurance policy. For example, It may be a waste of money to buy insurance when your house didn't succumb to a fire, but if it does, you cannot afford to be without insurance. Think of stock market investments in the same way.

One Option Strategy: Replace stock with in-the-money call options 

EXAMPLE
You own 300 shares of XYZ, currently priced near $58 per share.

Take these steps:

  1. Sell the stock, taking your cash out of the market.
  2. Immediately (do not wait for a "better time") buy 3 call options. The strike price should be in the money. In this example, you will probably want to buy the 55-strike call. However, the 50-strike call remains a viable choice if you are willing to accept additional downside risk. 
  3. Choose an expiration date that you meets your needs. The more distant the expiration, the more you must pay for the call option. However, a later expiration date offers portfolio protection for additional time.

If the market tumbles, all you can lose is the premium paid for the call options. If and when you decide to reinvest in stock, then you have a choice. Let's say that XYZ declines to $48. Obviously, you can buy stock at $48. Or you can continue the safety-first process by buying 3 new call options (selling the old calls, if there are any bids for them) struck at (i.e., the strike price is) $45.

Note that the stock declined from $58 to $48 and you lost only the cost of the cost call option. Other shareholders lost $10 per share.

If the market decline comes to an end and the market rallies, then you still have full control of 300 shares of XYZ. No matter how high the stock rallies, you get to participate in that rally. The only cost (the potential profit that you failed to earn) is the time premium in the call option. If you paid $5 for that call, the intrinsic value is $3 ($58 stock price minus $55 strike price) and the time value is $2. You will have lost the opportunity to earn that extra $2 per share -- but in return, you were protected against a large loss and participated in the rally. A very nice deal.

An alternative strategy involves buying put options (and keeping the stock), but I do not recommend it for novice traders because it is far easier to understand exactly what they own when the position is long call options. Owning a combination of stock and put options may cause confusion -- and that is something to be avoided.

Substituting long calls for long stock has its downside. First, you must truly understand what you are doing. You may not like the idea of paying capital gains taxes when selling your stock (assuming you held it ​from a price much lower than the $58 sale price). But, this strategy is intelligent portfolio management and it is something that you want to understand -- even if you choose not to take advantage of this strategy at this time.