How to Protect Yourself from a Red October in the Stock Market

A basic definition of a Red October in the stock market is one of carnage. Red October is synonymous with panic selling followed by a wave of bearish behaviour in the markets.

The Hunt for Another Red October could be occurning in the stock market this October as well.

Since this may not be fresh in everyone’s minds here is a Chart Displaying a Red October Last year in 2008.

This chart displays the S&P 500 as well as the TSX based on percentage changes. The steepest drop off in the chart occurred in October of 2008, which most people can remember as the mortgage meltdown.

During this time frame, most people lost a significant amount of money while a few bearish investors made fortunes. I was not lucky enough to be one of the bearish investors that made money in the stock market during the latter half of 2008, but I did learn a few lessons.

Fast-forward to late September 2009. I would like to highlight the bull V shaped rebound we have experience and then discuss the current implications. This next chart is the TSX alone so that a sense of the numbers can be displayed.

This chart displays the TSX over the past year from Mid September 2008 to the current time in September 2009. I have drawn in the mid-term up-trend line and a horizontal line at the most recent resistance level.

The current trend line has been chugging along nicely and has only really been tested 2 times throughout this cycle. As you can also see, the latest resistance level has sent the market on a collision course with the trend line, which it will likely test sometime next week.

There are many reasons that one might assume we are in for a Red October again this year, but that is not the point of this article. For reasons there is potential for a pull back in the market, take a look at the previous article titled Double Dip Recovery W or V shaped.

My main concern is discussing how one may protect their portfolio from such an occurrence. From my perspective, I am looking for efficiency and still want the ability to participate in further gains in case a Red October does not occur. This calls for the use of options, but don’t worry it is really very simple.

There are 2 methods that can be employed depending on your level of portfolio diversification.

1) You are well diversified

• Simply buy put options for the market index. You will want the options to be based on the stock market your main portfolio holdings are based. For me this would involve buying puts on the TSX. A couple of things you will need to remember is that the longer the time to expiration on the options the more they will cost and the higher the degree of protection you opt for the more it will cost.

• Personally, I will likely buy puts on the TSX. SXO – S&P/TSX 60 Index Options are my best bet since they track the TSX market. Since I want a large amount of protection and only believe I will need this protection for 1 month I will look at the SXO Nov 690, which currently has a bid ask of $35.50 to $38.15. Yes there is a big spread, but that is because there is not as much volume in Canada. If you are investing in Canada you may opt of S&P options on the NYSE for a better spread and similar market movement.

2) You are not diversified

• Under this scenario you may want to focus specifically on the stocks that you hold in your portfolio. For example is you on Suncor (SU.TO), you could just buy Suncor puts. The amount of protection you want will again be based on how long you think a correction could last and the degree of risk you are willing to take. If you want to protect all of your gains you will pick a strike price at or near the current market price of the stock.

Figuring out exactly how many options you need to buy is much easier with the second option strategy since you only need to match the amount of shares you have with the amount of contracts. For the first scenario you need to work out the dollar value of your portfolio in relation to the SXO index. If you have $200,000 then divided by the SXO index price ($200,000/670 = 298). Here you would buy 300 contracts or 3 lots since they trade in lots 100 contracts.

For more detailed information about buying options please review the bearish options strategies articles.