Buy Like Buffett: Profiting from a Stock Market Drop

The Dow Jones Industrial Average is churning upward and the Standard & Poor 500 index is sitting pretty as well. Excitement is in the air as investors are optimistic about the stock market and the business environment as a whole. Corporate profits are at record levels, companies are flush with cash and unemployment is dropping.

While all of these are great, investors should brace themselves for the inevitable market pullback that is to come.

Here are three things that you could do to profit from a market drop.

1. Trim your position.
   
   Jim Cramer of CNBC Mad Money has a great saying that applies to every investor: "[B]ulls make money, bears make money, pigs get slaughtered." Cramer's saying means that bullish investors make money by going long a stock as its shares rise. Bearish investors can make money by shorting a stock. Greedy investors will lose their money by holding onto a company for too long.
   
   If you have a sizable gain on an investment, then you should trim your position some. Reducing your position will allow you to realize some profits and still maintain some of your position. There aren't many feelings worse than watching a net gain on a stock turn into a net loss.


2. Buy protection for your position.
   
   If you don't want to sell any of your stock holdings, you don't have to. You can protect your investments by using options. Put options are great insurance for any investor that owns over 100 shares of a company's stock. Buying a put option gives you the right to sell your shares at a specified time and for a specified price.
   
   If you owned 100 shares of Panera Bread and bought one put option at a strike price of $90, your 100 shares would be protected in case of a market drop. The strike price is the price at which you can sell your shares. So, you would be able to sell your Panera Bread stock at $90 regardless of the market price.


3. Take a short position
   
   If you think that the market looks a bit overbought, it may be a great time to think about getting short. Shorting a stock is something that only an experienced investor should do and is only a small part of an investing strategy. Shorting a stock only works if its shares drop in a short time frame as expected.
   
   Shorting a stock involves borrowing shares from a broker who sells those shares at the current price. You have to replace the borrowed shares at a later date and hopefully at a lower price. Selling a stock short is a good strategy if a stock is way overvalued and is likely to take a dip.


4. Create a buying list.
   
   You should always have a buy list of individual investments that you would like to own. This could apply to any stock, bond, mutual fund, or exchange traded fund. This list is like your investing shopping list. When you go to the grocery store, you have a shopping list so that you can buy grocery items. You may load up on the items that are on sale. The same principle applies when investing. Keep an investment shopping list and when the market dips, load up.

These simple tips should help you to keep your portfolio protected against any setbacks in the marketplace.

Mark Riddix is the founder and president of New Horizons Financial Management, an independent investment advisory firm that provides personalized investing and asset management consulting. Mark is a regular contributor to Seeking Alpha and has written financial columns for Baltimore and Washington, D.C. area newspapers. Mark publishes his own financial blog, BuylikeBuffett.com and has written the book Your Financial Playbook.