What to Do With Stock When the Market Falls
It's important to have a plan for the inevitable stock market declines.
No stock or market goes up forever in a straight line -- and if it does, it probably means it's about to come crashing back down. Stock markets inevitably fall for a variety of reasons. As an investor, it's important to have a plan in place before it happens. Those who can foresee a fall can actually profit on the drop, or at least offset losses, with a simple options strategy. Otherwise, the best choice might be to take advantage of lower prices with new purchases, or simply take the loss and write it off on your taxes.
Sell Calls
1. If you're fortunate enough to identify a downtrend in the market just before it happens or early in the decline, one of the best ways to protect your investment is to sell calls. A covered call is the safest and simplest option strategy there is because it only involves selling calls against stock you own. Each 100 shares is equivalent to one options contract. Any call you sell will net you an immediate credit for the proceeds of the sale, and if the call expires worthless, you keep that money. If the call gets exercised, you keep the proceeds of the original option sale, plus the proceeds of your stock, which is sold at the strike price of the call options. The worst-case scenario is that the stock declines more than the proceeds you collect for the options sale, but even so, you're better off than if you hadn't sold the calls. The more accurately you can predict the duration and depth of the decline, the better able you will be at maximizing the proceeds of the option sale by picking the optimum series and strike price. Another benefit of this approach is that you can continue to collect dividends on the stock you own despite having sold calls against it.
Buy More
2. If you aren't fortunate enough to have foreseen a decline in the stock market, you can still take advantage of the lower prices by purchasing more shares. This approach requires caution and due diligence, however. While it's believed that stock indexes eventually revert to their long-term averages (a theory called mean reversion), a steep decline in an individual stock can signal a serious change in the company's condition that could prevent a return to higher prices. It's also risky to buy all at once without knowing if the decline has ended. If a company appears to be intact and likely to return to its typically higher prices, it's a good idea to make incremental purchases with the new cash you've allocated to the name. One approach, called dollar-cost averaging, involves buying an equal dollar value of shares over a certain period of time, with more shares being purchased if the price is low and less if it is higher. Another way is to simply decide on a number of shares and buy equal lots of shares until the predetermined quantity is reached. As with covered calls, you continue to collect dividends on stock (assuming the company continues to pay them) and actually capture a higher yield by purchasing at lower prices.
Take Losses
3. No one likes to lose money, but one good thing capital losses are good for is offsetting capital gains. If you happen to have significant capital gains in a particular tax period, you might elect to take a loss on stock that has fallen to lower your tax liability. If you choose to do so, however, be sure to consider the IRS wash rule, which could prevent deducting capital losses if they were incurred 30 days before or after the acquisition of substantially identical stock. In other words, you can't take a tax loss on stock that you've held for less than 30 days, and you can't reinvest the proceeds of the sale into the same stock for 30 days after the sale or the loss will be disallowed for tax purposes. Also be aware that if your capital losses exceed your capital gains, you can only deduct the excess up to $3,000 in a single year (the rest can be carried over to future years).
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