Become a better investor
Lesson in Course: Stocks (expert, 6min )
I have started buying stock for my portfolio and I anticipate a bumpy ride in the future. What can I do?
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. Read more about downside risk here.
Hedging refers to buying an investment designed to reduce the risk of losses from another investment—we can think of it as buying insurance. When times are good, the insurance is not needed. 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.
A trading strategy that many investors use that seemingly doesn't cost anything is a stop loss. 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. The goal is to limit or prevent losses in a declining market, thus earning the name stop loss.
We rank stop losses a 3/5 for effectiveness and 5/5 for ease. It's easy to set up these orders; however, it can lead to larger than necessary losses.
A second strategy is to buy put options on our stock position. Read more about options here. A put option allows us to sell our shares to someone else at a predetermined price, called the strike price.
We rank put options as 5/5 for effectiveness and 4/5 for ease. It's easy to buy a put option. The only requirement is understanding how options work. A put option also provides sizeable protection in large market movements.
A third strategy is to sell or write out-of-the-money covered call options on our stock position. 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.
We rank covered options as 4/5 for effectiveness and 2/5 for ease. It doesn't have much protection compared to a put option in significant market downturns; however, it provides a steady income. The difficulty is the amount of money needed to own at least 100 shares.
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 for us, but the strategies are meant to be mixed to cover another's pitfalls. Being effective in using options requires a good understanding of derivatives. We recommend passing all the lessons in the Derivatives and options course before starting.
Hedging refers to buying an investment designed to reduce the risk of losses from another investment.