Interest rates are rising across the globe as central banks and market participants start preparing for higher inflation. The Fed, the ECB and the BoE may have kept interest rates unchanged, but inter-bank rates have crept up and are moving higher.
In Emerging countries like China, Brazil, India and other Asian tigers, the central banks there are already raising rates to fight off inflation and the effect of such rate increases is starting to show.
Take India for example. India’s central bank increased interest rates to deal with inflation that is rising at more than 8% per year. China is in a similar position. In an attempt to control runaway inflation, China recently hiked its rates by a quarter percent, its third hike since the start of the year. One of the main casualties of rising interest rates are stocks. India’s benchmark stock index, the Sensex is plummeting right now…and could be a good example of what may be in store when developed markets start increasing rates.
With stock markets tightly linked to each other, there is an acute risk of domino effect hurting sentiment and stock prices. On the other hand, repeated comments by Fed Chairman Ben Bernanke that interest rates will not be raised until the US recovery is in full swing and the unemployment rate starts coming down are the reason why investors in the US keep pushing stocks higher. The S&P 500 index recently crosses above the 1320 level, its highest since 2008 when Lehman Brothers went bankrupt and is in a broad uptrend.
But sometimes the market does not wait for the actual policy turn and moves ahead of the curve. That is, stocks could turn lower, much earlier than when the Fed will actually announce a rate increase.
The best way for those who are fully invested in stocks is to protect their portfolio by using trailing stops. This way, you allow your winning positions to continue to earn money, but if there is an abrupt turn in the market, the positions will be closed at the level that you have indicated and you lock in your profits.
There is no magic formula as to where your trailing stop should be. It could be 10% from current levels – which means if the S&P500 index drops from the current level of 1320 to 1188, then automatically you would close your positions. Other investors, especially those who are riding the bull market from much lower levels, may be able afford a bigger trailing stop of say 20 or 25%. This way, if the S&P 500 index would drop below 1055 or 1000, the positions would be automatically closed.
Investors not accustomed to trailing stops may however be frustrated when their stops are triggered and then the market continues higher. This is the process where the market does a retracement or correction and then resuming its march. For this reason, the trailing stop should not be very close to current prices and should be placed below strategic levels, such as when the 200-day moving average is breached, or when technical indicators start issuing warning signals.
That’s why for a stock portfolio trading on a long term horizon, the 25% trailing stop is possibly more convenient compared to a forex portfolio with a much shorter investment horizon. Since in the forex market, the majority of investors trade on margin and leveraged positions, a 2% to 3% trailing stop is the standard practice, since in forex, a small swing in prices risks wiping off the entire investment.
At Eurivex, a regulated Cyprus Investment Firm which offers forex white label and forex start-up brokerage complete solutions, we prefer to place our stops at only 40 pips whereas keep our profit targets at 50-100 pips.
I understand that at times it’s a frustrating strategy when the stops are hit and then the market reverses, but at least you don’t lose your sleep over a position and you are closer to the ideal investment strategy of cutting your loses while letting your winning positions run.
Article Source: http://www.articlesbase.com/currency-trading-articles/protecting-a-stock-portfolio-against-rising-inflation-4674394.html
About the Author
Shavasb Bohdjalian is an approved Investment Advisor and CEO of Eurivex Ltd., a Cyprus Investment Firm, authorized and regulated by CySEC, license no. 114/10. Forex Brokerage and Investing in markets and trading on leverage is highly risky and it may not be suitable to all investors since it carries a high degree of risk and you can lose more than your initial investment.
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