Sleep Well Like Buffett With These 3 Steps to Stay Safe in a Volatile Market

Earlier this week, I wrote an article stressing the importance of having a game plan, just in case we experience additional market downside. A comment on that article from a reader indicated that he felt unprepared for the current level of market volatility.

It occurred to me that many individuals are unprepared, because for many years, they have been rewarded for being bullish. It might be helpful in a time like this to think about Warren Buffett.

Imagine Warren Buffett at night, enjoying a peaceful sleep. He’s not worried about the markets, because he’s put himself in a position to benefit from whatever happens next.

If the market rises, Buffett is long what he believes are the best stocks out there. If the market falls, he has plenty of cash on hand to scoop up any potential bargains.

In addition to Buffett, there are traders at Goldman Sachs GS, JPMorgan JPM, and other institutional firms that are also sleeping well. They know that there is an opportunity for profit regardless of market conditions. They know how to make money in a bull market as well as in a bear market.

If you’re sweating the gyrations of this market, you need to think more like the professionals mentioned above. In order to be more like them, ask yourself this question:

Am I Managing Risk?

You might think your job in the market is to make money, but you’re wrong. Your job is to manage risk.

Without risk management, you’ll have the capacity to achieve gains, but those gains will often evaporate. Become a good risk manager, and you’ll hang on to the lion’s share of your gains.

For example, do you have a predetermined exit point for every trade or investment? There should be a figure that you’re not willing to exceed when it comes to losses.

In William O’Neil’s How to Make Money in Stocks, the author advises readers to cut losses when a position is down by 7% to 8%. Successful short-term traders often limit their risk to less than 1% of the value of their account. That way, the likelihood of a large loss is diminished. 

This technique can also be used to manage risk on an entire portfolio. For example, if the value of the portfolio falls below point X, the account owner must immediately close all trades and reevaluate the situation. It’s much easier to be objective with a flat account.

How Much Money Am I Risking Right Now?

During the early part of this century, there were two major stock market crashes, in 2000 and in 2008. In both cases, the S&P 500 was approximately reduced by half, along with many stocks and mutual funds.

If the markets were halved again tomorrow, how much would you lose? Ask yourself this tough question. If you don’t like the answer, it’s time to reduce your exposure.

Understand Protective Puts

We insure our homes and our automobiles, but do we know how to insure our portfolios? If not, it’s time to learn about the power of protective puts.

A put is a type of option that can be used as insurance on a long stock position. If the stock goes against you, you can literally "put" that stock out of your account at a more favorable price, as long as your put option — which is basically a coupon — hasn’t expired.

This tactic might come as a surprise to folks who’ve been taught that options are dangerous. The options themselves aren’t dangerous. It’s the traders who use options as tools for gambling that are a danger to themselves.

Options have a variety of uses, but if you have any significant money in the market right now, then it's time to learn how to protect your account via put options.

Bottom Line

Risk management is a professional approach to the markets that can keep investors safe during volatile stretches. True professionals are always thinking about risk management, even in the best of times. If you want to sleep well at night despite volatile markets, make risk management your top priority.