There was a lot of fear in the mailbag this week.

Last week’s market selloff has folks on guard for a larger decline. A lot of you wrote in looking for my thoughts on how to prepare for a correction…

I, and I am certain many others, would be interested in your thoughts on how to prepare for a serious market downturn whenever it happens. Your weekly articles are always thoughtful and insightful and I watch for them.

– Hildege

Thanks for the question, Hildege.

As I mentioned on Tuesday, stock markets don’t crash when everyone is looking for it to happen. And crashes don’t happen when the important moving averages are in a bullish configuration (which they are right now).

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So, while there is certainly the potential for a 5-7% correction over the next month or two (September is approaching, after all), we probably won’t see a larger decline than that until sometime next year.

The easiest way to prepare for that is to raise cash. It is far easier to sell stocks in a rising market (where there are plenty of willing buyers) than to sell stocks in the middle of a sharp decline (where everyone is rushing for the exits).

Raising your protective stops on your holdings is also a good idea. But the use of stops is not as protective as you might think when stocks gap sharply lower. That’s why I prefer to raise cash by selling stocks into strength.

Of course, owning typical “safe-haven” assets like precious metals and precious metals stocks can also help when the broad market sells off. Money flows out of “risky” assets and into perceived “safe” assets like gold and silver. Owning gold and silver ahead of time is a good way to prepare.

Finally, you can hedge your portfolio with a well-timed short sale or two. Selling stocks short offers the possibility to profit as the market falls. The profits on your short trades will help offset some of the damage on your long portfolio. But – and here’s the tricky part – you have to get the timing right on your short trades. If you go short too early and the stock runs 10% higher, then you won’t get much of a benefit to a subsequent 10% drop in the market.

Most folks, including yours truly, tend to be early on short trades. If you can patiently wait for the broad stock market to reach extremely overbought levels, then you’ll have a better chance of getting the timing right.

By far, though, the most important thing to do to prepare for a large market decline is to simply raise cash. That way, you’ll suffer less when the market falls and you’ll have plenty of money available to go bargain shopping after the bear has torn everything to shreds.

Did you mean 9-day EMA/50-day MA in Tuesday's Market Minute? Maybe I'm hallucinating but I thought we most often looked at the 9-day EMA and 50-day MA for bullish or bearish crosses. Thanks.

– Steven

Hi Steven.

You’re not hallucinating. When we look at daily charts, we use the 9-day exponential moving average and the 50-day moving average.

But the chart I showed on Tuesday was a WEEKLY chart of the S&P 500. On that timeframe, the relevant moving averages are the 9-week EMA and the 50-week MA. The moving averages need to be consistent with the timeframe of the chart.

So, if you use intraday charts to set up quick, short-term trades – like, for example, when I refer to a 15-minute chart of the S&P 500 – the 9-period EMA is calculated by using nine fifteen-minute periods. The 50-period MA uses 50 fifteen-minute periods.

I hope that clears up the confusion.

Best regards and good trading,

Jeff Clark

P.S. If you have a question about option trading you'd like to be featured in one of our Friday Mailbag issues, send me an email right here.