The stock market is rallying and causing euphoria and FOMO among investors. You may be happy with the market rally but there is a danger brewing below the hood. And that danger is getting bigger and bigger. How to protect your account from drawdowns during corrections?
 
 

 

Stock Market Rally

 

It is nice watching your positions going up and making money. Reddit is full of people boasting about their gains. They are laughing at people like me for nibbling my trades and collecting small income. But ultimately, when the markets reverse, they will blow their accounts while mine may survive.

The recent rally is outstanding but there is a silent danger brewing. It is not visible and many ignore it. So what danger is it? Volatility. Despite markets rallying, nervousness among investors and traders is increasing. It is creeping up slowly, little by little. And at some point, it will reach levels that are not sustainable and we will see a correction, or even another crash and bear market.

But, don’t get me wrong. This rally still may continue for a long time before we see something meaningful. But it is my opinion that it is time to start slowly building a protective wall in your portfolio to get ready for a big move should it happen.

 

Stock Market Score

 

For a long time, I was thinking about a system that could provide me with early warnings to get out of risky positions when the market is ready to crash. I was collecting data on strategies that I can use to create a barometer, or score system that would allow me to stay focused on data and minimize my opinions when rotating from risky trades or protect them from large drawdowns.

I collected 30 metrics that I believe would provide me with exactly that. These metrics are a combination of technical, fundamenta, economic, and volatility data. All put together created a barometer that would be similar to those you may find on other websites like the CNN’s fear and greed index. But that index doesn’t tell me whether the greed is still going to rage in the markets or we are at the end of the rally and the market is about to lose its momentum.
 

 
The chart above does that for me. It shows where the market is today. The current reading is 83 which tells me that we have a strong rally that is nearing to its peak. When the markets starts losing legs, this barometer will drop and it will drop even when the stock market is still going up. That will be a warning.

But the most important metric in this whole barometer thing is the rate of change of volatility metrics in the barometer. That number is currently sitting at 47%. It is also a very high number, confirming my concerns indicated in the barometer above. When this number spikes above 50% and stays there, we have a problem.

 

How to Protect Portfolio in This Stock Market?

 

This is a very individual and I can only suggest what I am doing in my portfolio. You need to do your own research to come up with your own protection.

But here is what I will do. First, let’s establish what I invest in and what I need to protect.

I invest into dividend stocks. Those are stocks that I want to keep forever (well as long as they keep paying dividends). When the barometer and rate of change is this high, I will not be adding to the existing or opening new positions. But I will keep what I have.

Instead, all income, options trading proceeds, and dividends will be invested into instruments that will increase in value when the markets crash.

I invest in SPXL (a former HFEA strategy that I pretty much abandoned) but I still keep investing into this leveraged instrument. But in this volatility environment, I am adding cash into SPXS instead. SPXL is 3x leveraged bullish ETF that tracks S$P 500, while the SPXS is 3x leveraged bearish instrument. As the market and volatility keep going up, I will be adding more and more shares of SPXS to my portfolio. When the markets crash, the SPXS will increase in value and provide some protection.

I will not go crazy on SPXS (it is a very bad investment vehicle long term as it constantly loses value during resets, but it can provide a nice return when the markets dip. In the last market correction from July lows to October highs, the SPXS returned 38.6%.
 

 
But again, this is an insurance, it will be losing money long term, so I will be investing small amounts of money into this ETF.

 

Reducing SPX and Futures Options Trades

 

When the rate of change of the barometer exceeds 50% (and it already happened on March 11, 2024, and stays above 50% or even keeps going higher, I will be drastically reducing my open options positions and not opening any new ones (or opening bearish ones only such as selling calls against Micro futures, or call spreads against E-Minis or SPX).

 

What about stocks?

 

I own dividend stocks as I mentioned above. These stocks need to be protected too, so when the market volatility rate of change goes above 50%, I will be trading collars (where available) or selling futures option to generate income that I will use to buy puts against the stock positions.

You may ask why not sell your stocks and buy them back after the crash or bear market? That is a strategy that I do not want to use. I want to own these businesses and collect dividends. Over the years I owned stocks of these businesses, my yield on cost is so high that starting over is not a prospect I would like. Many investments in my portfolio have their cost basis so low that these stocks would have crash a lot to get the same price I own them for today. So I would rather protect them by buying puts then selling my positions.

 

Conclusion

 

Of course, these measures will not eliminate risk completely, but mitigate and lower my drawdowns during corrections or bear markets. I started implementing some of the protective features into my portfolio during 2021 and beginning of 2022 and although I was not able to implement them fully (I started too late), my portfolio outperformed the S&P by almost 12% in 2022 bear market (the market crashed 32% my portfolio dropped by 20% only). I would like to have all my ducks in a row ready for the next bear market. I think, the strategy outlined here will mitigate my losses or even make my portfolio profitable.