In the last lesson, we discussed the various aspects of what an economic bust is – with the presumption that it will be able correct itself, as an economic boom were to surely follow – but we did not go into further detail of the ramifications of how to proceed if the worst case scenario were to occur – but rather, gave you a general idea of what to do and expect. In this lesson, we will be showing you how to survive an economic collapse when the market takes a turn for the worse, as it is vital to handle these disasters in a cool, calm, and collected manner.
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Disclaimer: Invest In Wall Street is in no way financially or legally responsible for any investing decisions made by any of our readers and are, in turn, acting on their own free will. The information in this article is purely educational and should not be abused or misconstrued in any way, shape, or form.
From time to time, the stock market experiences a downturn. These downturns vary by length and degree.
Some downturns are short-lived and relatively harmless, while others are long-lasting and severe.
Most investors watch for downturns by monitoring a major index, such as the S&P 500. The degree of a downturn is
determined by how far the S&P 500 has fallen from its recent high.
If a downturn becomes severe, you may want to take defensive measures.
There are generally three degrees of downturns – The first is a minor downturn, which can be categorized as any time the S&P 500 has fallen less than 10% from its high. Minor downturns are quite common, and technically, any downward movement at all is considered a downturn.
If the S&P 500 falls 10% or more from its high, its considered a more worrisome downturn.
A drop between 10% and 20% from a high is considered a correction and is fairly common.
The most serious downturn is when a correction turns into a full fledged bear market. A bear market is when the S&P
500 drops 20% or more from its high. The risk in a bear market is that the S&P 500 could continue dropping and drag most stock investments with it.
The S&P 500 has dropped more than 50% during some of the worst bear markets. For instance, during the financial crisis in 2009, the S&P 500 dropped 52% from its high.
The goal of identifying and measuring downturns is to try to limit losses. In addition to monitoring the S&P 500’s high, there are two other ways to identify and measure downturns.
Identifying Market Downturns
The first is identifying the S&P 500’s long term diagonal support levels. A break below a diagonal support level could mean that a downturn is becoming more serious, but this technique has its limitations.
Depending on the locations of diagonal support and recent highs, the S&P 500 might already be in a correction, or even a bear market, by the time it breaks diagonal support.
A more dynamic way to identify and measure a downturn is by using moving averages such as the 20, 50, and 200 day.
The 20-day moving average tracks the S&P 500 the closest. Generally the 20-day moving average is no more than 4% away from the index. This means if the S&P 500 breaks down below the 20 day, it can be an early indication of a pending correction or a 10% drop.
The 50-day moving average tracks the S&P 500 less closely. The 50 day is generally anywhere from 4% to 8% away from the S&P 500, although there are times when its more than 10% away. If the S&P 500 falls below the 50 day, it can be a stronger indication of a correction.
The longest moving average is the 200 day. This moving average is probably the most important when it comes to measuring a downturn. If the S&P 500 falls to the 200-day moving average, its probably already down 10% from its
high and in a correction – that’s why investors pay special attention to the 200 day. A break down below this level can lead to a deeper downturn, and sometimes indicate a bear market.
Now that you know how to identify and measure downturns, let’s discuss what you can do to handle one.
Handling Market Downturns
First, consider your time horizon – if you have a long time horizon of 10 plus years, then you may not need to do anything at all.
However, if your time horizon is shorter, or if you want to take defensive actions, then here are a few tips:
1. Sell your stocks to a level that’s consistent with your risk tolerance. This is the first and simplest way to reduce your exposure by selling your stocks to a level that’s consistent with your risk tolerance, and keeps the sales proceeds in cash.
This might include selling a portion of the stocks that the S&P 500 breaks below its 50 day moving average and another portion of it breaks below its 200 day.
The risk of selling these investments is if the market stops falling and starts moving up again, you will miss out on a huge upswing when the market finally corrects itself.
2. Use Put Options. The second and more advanced way to handle market downturns is by using put options. Buying a put option gives you the right, but not the obligation, to sell your stock at a specified price at any time through a specified future date. Put options can also be purchased on many indices.
Some investors buy put options on broad based indices as a temporary way to possibly minimize the damage of a downturn, rather than selling individual investments.
The gains made from put options can help offset losses in the individual market they cover. The risk of put options is that its possible to lose what you paid for the puts.
But perhaps the best way to handle a bear market is by making small, calculated decisions as a downturn progresses – as taking small, defensive measures along the way can give you some flexibility.
Whether you sell stock investments or buy put options, try to avoid making emotional decisions when the market turns down.
- From time to time, the stock market experiences a downturn. These downturns vary by length and degree.Some downturns are short-lived and relatively harmless, while others are long-lasting and severe
- Most investors watch for downturns by monitoring a major index, such as the S&P 500. The degree of a downturn is determined by how far the S&P 500 has fallen from its recent high
- The most serious downturn is when a correction turns into a full fledged bear market. A bear market is when the S&P 500 drops 20% or more from its high. The risk in a bear market is that the S&P 500 could continue dropping and drag most stock investments with it
- The goal of identifying and measuring downturns is to try to limit losses.
Identifying Market Downturns
- There are three ways to identifying market downturns…..
- Monitor the S&P 500 – Watch for the highs, lows, opening, and market closing prices
- Use Support & Resistance – Look for uncharacteristic breaks
- Use Various Moving Averages – If price breaks below the longest MA, it could potentially signal a deficit
Handling Market Downturns
- There are three ways to handle market downturns…..
- You May Not Have To Do Anything At All – This of course depends on your investing goals and time frame
- Sell Your Stocks To A Level That’s Consistent With Your Risk Tolerance – There is also the possibility that you miscalculated the downturn and it corrects itself with a bullish rally
- Buy Put Options – Buying a put option gives you the right, but not the obligation, to sell your stock at a specified price at any time through a specified future date
And there you have it. There are a plethora of ways to find, analyze, and proceed when it comes to an economic collapse, although these are the most common ways to deal with them. This all boils down to your investment objectives and risk tolerance.
There may be times when action may be required to protect the equity of your capital, while other times, it may be best if you do absolutely nothing…..as an economic collapse to the magnitude of the Great Depression is uncommon, but, still very much possible. The choice is ultimately up to you to figure out how you would like to proceed going forward if a hypothetical situation such as this were to occur – just remember to be prepared.
I hope you have enjoyed this post and found the information to be quite useful. If you have any questions or concerns, please feel free to leave them down in the comment thread below and make sure to like and share this post.