How to Play the Coming Downturn

The latest market downturn has been brewing, in my mind, for the last two months.  And we've been a bit too sanguine about the prospect, considering that the gains in the indexes have been so strong, but the time has come to make some sweeping changes to the portfolio, both in energy and outside of it, to protect those gains going into the 3rd and 4th quarters.  

There's still a lot to protect and all the risk seems to me to remain on the downside.  But knowing my penchant for dividend and distribution producing stocks like MLP's, there's a tricky way to do this besides throwing in the towel, merely selling shares and giving up on stocks.  

One of the biggest sins of trading is in not booking profits and watching them melt away - and in the smaller cap E+P's and newly IPO'ed MLP's that I've been concentrating on for the last several months, there's quite a bit of profit to book. The way I've been doing it for the past weeks is with slightly in-the-money or even slightly out-of the money calls, selling them with expirations from October 2013 to January of 2014.  

Here's my thinking:  With most of the likely profits for 2013 already represented in our shares, we want the market to pay us for the privilege of owning our shares a bit lower.  That's what a covered call strategy basically represents; earning a premium for the probability of having our shares called away at a future time.  If the market stays flat from here, we've taken in premium while maintaining our portfolio as it stands.  With a dropping market, we've booked some profit and given our stocks more time to recover, without sacrificing the dividend payment.  If the market somehow continues to show strength, we'll have to liquidate positions, but at a higher relative price than they're trading at now.

All three of those scenarios seem to me to be positive.  The lone negative is a market that bleeds away by more than 10% here and makes us sorry we did not just liquidate positions and raise cash more directly.  I see that as least likely, even with less than exciting earnings reports just in.  

This is how I've 'hedged' virtually my entire energy portfolio, selling calls on top of BP, SD, CVRR, APC, EOG, HK and a host of other  energy names I hold less significantly.  

The one place I've gone the opposite way is in natural gas names, where I've actually used the downdraft to sell puts, daring the market to make me increase my length.  Most of these names, like ECA and UPL have shown such consistent weakness that further down moves strike me as opportunities.  

Both of these are sneaky methods of booking profits and adding to stagnant names that I think are moving into value territory, but also help to increase returns outside of simple "buy and sell" strategies.  

It's what I'm recommending now, as the markets have shown some very tepid action in the past two weeks' sessions and have me playing a bit more defense.