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Posted on 22 September 2013 | 2,452 views

How Hedge Funds Brace for Stock Market Crashes

Investors do worry about stock market crashes when stocks have rallied such as the case in 2013, but what retail investors should do is try to learn what the professionals do with their clients’ money and their own money. Very few fund managers sell out of stocks entirely. After all, cash never rallies, and it is widely known that bull markets always seem to crawl a wall of worry.

The last thing that a portfolio manager wants is to see a stock market crash rob them of their strong performance. Imagine trying to explain to clients how you wanted more upside even after stocks have more than doubled from the lows of 2009, even with all the warning signs that were evident in August of 2013.

As we head into the last quarter of 2013 we are going to see more “2013 Stock Crash Warning Signs” and October produces the largest stock market crashes which puts people on edge.

Here are some strategies retail investors should consider when the start to become nervous about the stock market environment.

Starting an Exit — if you have doubled your money you can sell half of your position, effectively taking your cost basis down to zero for the remaining position.

Sell Call Options — writing a call option is a great way to start letting your stocks produce income, even if a stock pays no dividend. By selling call options, covered calls that is, fund managers are able to make income, and they are able to specify that they are willing to sell a stock if it reaches a certain price by a certain date.

Buy Downside Protection — buying a put option that is only slightly out-of-the-money. A put option is a contract that gives a stock owner the right to sell the stock at a set price, even if that stock price falls 20%, 40%, 60% or worse.

Shorting Spyders — if a portfolio is largely correlated to the broader stock market, it is possible to short-sell the S&P 500 futures or the SPDR S&P 500 (Ticker Symbol: SPY) while still holding the stock(s). It effectively locks in gains or prevents losses if the markets fall. Fund managers can still sleep at night without much stock market risk.

Going Defensive — many fund managers may decide to rotate out of riskier technology or biotech stocks and “hide out” in defensive stock sectors that are unlikely to suffer major losses out of the blue. The one catch in going defensive is that if the stock market is going to fall 10%, 15%, 20% or more in a short period, then defensive stocks likely will collapse as well because of the extreme move and panic. Generally and historically, defensive stocks fall much less than high-growth stocks, even in times of panic.

How Hedge Funds Brace for Stock Market Crashes

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