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Limiting losses and covering bases

Lesson in Course: Stocks (expert, 6min)

We started buying stock for our portfolio and we anticipate a bumpy ride in the future. What can we do?

Eureka!

What it's about: Managing risk and potential losses is a critical piece of successful investing.

Why it's important: Hedging strategies are how we protect ourselves from big losses during market downturns.

Key takeaway: A combination of stop-loss orders and option contracts can provide us with the insurance we need.

Hedging one's bets is an idiom coined in the 1600s, and investors have been thinking of risk management ever since. When our portfolios only contain a few individual stocks (holding concentrated positions), hedging provides much-needed protection against volatility.

What is Hedging?

Refers to buying or selling an investment to reduce the risk of losses from owning another investment.

We can think of it as buying insurance. During times of trouble, the insurance kicks in and helps prevent deep losses. Let's go over three ways we can hedge our risks on individual stocks.

Stop losses

Stop-loss order try to prevent losses when prices drop

A stop loss is an order that provides the broker the instruction to sell a pre-determined amount of shares if the share price drops below a threshold. We can place these orders with our brokerage as a trading strategy to limit or prevent losses in a declining market. It's easy to set up these orders; however, they can still lead to larger than expected losses depending on the market conditions.

The good

  1. Stop losses are very easy to set up and are valid for up to 90-days on all major platforms allowing many investors to set it and forget it.
  2. Stop losses come in different flavors to give investors more control. They can either be a plain stop loss, a stop limit, or a trailing stop limit.

The bad

  1. Stop losses are mechanical and may not work as intended. In panicked markets, a stop loss could trigger, and if the broker can't match a buyer, the shares sell for much lower than the stop price set resulting in huge losses. The next day, if markets recover, the steep losses from the previous day are locked in.
  2. Stop losses result in selling the shares and may cause us to owe taxes if we realize gains.
 

Buying put options

Another strategy is to buy put options on our stock position. 

Put options become more valuable when prices drop

A put option allows us to sell our shares to someone else at a predetermined strike price. They also provide sizeable protection during large (or wild and crazy) market movements. It's easy to buy a put option, but we need to understand how options work for this strategy to be effective. 

The good

  1. Options offer flexible time coverage for the insurance we need with different length durations
  2. In panicked markets where the stock price slides rapidly, options can be worth much more than the stock's losses
  3. Buying a put option doesn't require selling our stock

The bad

  1. Buying options cost a premium, just like insurance
  2. If we don't use the option, we lose out on the premium, just like insurance
  3. Trading options is more complicated than stocks, where mistakes could make matters worse for us.
 

Selling covered call options

A third strategy is to sell or write out-of-the-money covered call options on our stock position.

Selling options generate a return or income

This strategy allows us to continuously collect an income from the premiums of the call options sold. Selling a call on our stock positions means selling another investor the right to buy our shares at a higher price than they are now. If the stock price goes down, the buyer will not exercise, and we collect the premiums. If the stock price goes up, the other investor buys our shares at the predetermined strike price.

The good

  1. This strategy allows us to generate income while holding shares
  2. Win/win if the stock price goes up or down
  3. Writing a call option only requires selling our stock for a profit

The bad

  1. We need to own 100 shares of the stock for each call option contract we write.
  2. In massively declining markets, the cash collected from premiums won't offset the losses of holding the stocks.

Selling a covered call option doesn't give more protection than buying a put option; however, it does provide a steady income from the option premiums. This strategy is harder to use because of all the money needed to own at least 100 shares.

 

Actionable ideas

These are 3 common effective and actionable strategies to protect against losses used by investors today. There is no single strategy that will provide everything, but they can be combined to cover each pitfall. 

Being effective in using options requires a good understanding of derivatives. So it's better to stick to using stop-loss orders until you've learned how to trade options.

 

Glossary

What is Hedging?

Refers to buying or selling an investment to reduce the risk of losses from owning another investment.