Small-cap stocks have had a rough few weeks.
In fact, the decline has been so sharp that for the first time in seventeen months the Russell 2000 touched its 200-day moving average. The 200-day is an important level because a breach of the line oftentimes signals a long-term trend change.
It’s certainly worth keeping a close eye on. There have been 11 times where the Russell 2000 broke below its 200-day moving average after spending over 200-days trading above that level. In almost every occurrence, the small-cap index was lower several weeks later and the returns were still overwhelmingly negative after three months.
Should we really be surprised to see a stock market correction?
We’ve gone months without a “normal” correction. And from a seasonal perspective, the timing couldn’t be more perfect. “Sell in May” is just beginning to enter the minds of investors. And as history has shown, the period between May and October have been overwhelmingly bearish for the market.
How bearish? A $10,000 investment in the S&P 60 years ago would equate to approximately $446,000 during the months of November-April. In comparison, the May-October timeframe saw a paltry gain of $6,544.
We’ve already witnessed an 8.7% decline in the small caps, and if history holds true we should expect to see more losses going forward. Just remember, many analysts consider a 10% to 20% correction normal, so now is certainly not the time to panic. Of course, precautions should be taken, but more importantly, you should be excited about the prospects ahead. Stock market corrections lead to opportunities.
In my case, as an options trader, stock market corrections create the best opportunities. Not because I want a market decline. I just want market volatility to increase. And the best way for volatility to increase is by increasing fear in the market.
As fear increases, investors buy more puts to hedge losses in their portfolios. The surge in purchasing this form of investment insurance creates an increase in volatility, as seen through the VIX, which has a direct impact on the price of options.
Also known as the Volatility Index, the VIX, is a simple index that measures the market’s expected movement in the S&P 500 over the next 30 days.
Basically, as market fear increases, the price of options increase. As a seller of options, or market insurance, I benefit greatly when prices move higher. Just think about it, I can sell the same insurance I sold a few months ago for a significantly higher price when market fear enters the marketplace. And that’s why so many professionals, particularly options professionals, thrive during time of market duress.
If indeed, the Russell closes below its 200-day moving average, history suggests the small-cap index will continue the trend lower. How will you choose to prepare?
On Thursday, I will be discussing, in great detail, how I am preparing for the upcoming spike in volatility. If you are interested in hearing about my three strategies please click here to join my free live webinar.
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