When the pharma stocks like Sun Pharma and Lupin first started to correct in 2015, Ashok Gupta was not worried. After all, “how can Sun Pharma and Lupin correct”, was his standard refrain. Unfortunately, the stock remained in a downtrend for the next 3 years and is only now showing some signs of recovery. But the stocks are still way below Ashok’s acquisition price and it could take a long time for him to get in the money. Is there is a pre-emptive method of being in Ashok’s shows? The question is how to protect stock gains and how to protect investments from stock market crash. This can be a sector specific fall in prices or market level value destruction (as we saw in 2008) after the Lehman crisis. Let us understand what stock protection is and how to apply it. The seven techniques pointed below are not just about hedging but also about restructuring your portfolio...
1. When in doubt; shift to quality
If you consider the last 20 years, then stocks like HDFC Bank, Hero Moto, Reliance Industries, Eicher Motors are all classic examples of stocks that have shown consistent performance. These are the kind of stocks who will show consistent performance if you consider a moving average approach during any time period. Even in the worst of times, they protect value. What sets these companies apart is their focus on the top-line and the bottom-line as well as the quality of their business. Use the opportunity of a falling index to move your portfolio towards quality.
2. No two rallies are driven by the same set of stocks
If you look at the markets rallies in the last 25 years, rarely are two sets of rallies driven by the same stocks. It was cement in 1992, technology and media in 1999, infrastructure and realty in 2006, automobiles and private banks post 2013 and consumer goods companies since 2017. When the froth is coming off the dips are hardly a buying opportunity. This is the time to focus on stocks like which are going to drive the next rally and not the stocks that drove the past rally.
3. There is no protection like opportunism and that is about buying at lows
An interesting question is whether one must remain in equities or shift to debt altogether. Then you can use the liquidity of debt to buy stocks at lower levels. That is an extreme asset allocation approach and is neither recommended nor feasible. What one should do is to increase the allocation to debt and reduce the allocation to equity in a gradual manner. For example, if you stayed invested in equities through the 2008 correction, you will not have the heart to book losses and you will not have the liquidity to buy the stocks at salivating levels. Had you kept liquidity ready to buy stocks in 2003, 2009 or even in 2013, your returns over the next 5 years would have been humongous.
4. Asset allocation is your natural hedge against valuation and liquidity
In a way, this is an extension of the previous point. An important rider here is that you must adopt a rule-based approach to asset allocation. Asset allocation is about discipline and the advantage of this discipline is that your allocation automatically moves contrary to the market valuations. This is popularly known as a counter cyclical approach. For example, if the stocks move up and the equity allocation goes up beyond the limit then you are automatically pushed towards debt. Similarly, if the debt portfolio has appreciated due to a sharp fall in interest rates, then automatically more money gets allocated to equities at lower levels. This will ensure that you are invested at relatively higher levels and liquid at lower levels.
5. Use the power of futures to lock in profits
The funny part about markets is that you never know how long the good times will last. The best way is to monetize some of your profits through locking in via futures. When you sell equivalent futures against your cash market positions, then you are locking in the profits. Irrespective of what happens to the stock price you always have the assurance of the locked in profit. Better still you can keep rolling your short position in futures each month and earn the futures spread each month. That is your monthly interest income on the portfolio.
6. How about protecting your risk with options
Put option offer you the right to sell without the obligation to sell. If you are holding on to Reliance Industries, you can hedge your risk by buying a lower put option. Once the put premium is covered, you are full protected. Yes, you have a cost in terms of premium cost but that is a cost worth taking on especially when your portfolio gets protection. You may not be able to protect with stock options each time and you can also look at index options to protect your risk at an overall portfolio level.
7. Protect your downside risk via diversification
This is one of the most common techniques of protecting the downside risk of your investments. When you diversify, you spread your investments across assets. You can either do equity diversification where you spread across sectors and themes. Alternatively, you can also spread your portfolio across other asset classes like debt, gold, realty, structured, products, securitized assets etc. This diversification will give you automatic hedge against volatile market conditions.
Falling markets have two dimensions to it. Some of the finest traders like George Soros, Stanley Druckenmiller, Paul Tudor Jones or John Paulson have made money in falling markets. It is all about being greedy when others are fearful and being fearful when others greedy. These basic rules can surely help you along!