Archimedes Finance

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Limiting losses and covering bases

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.

Stop losses

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. 

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.

 

 

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.

Buying put options

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.

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

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.

 

Selling covered call options

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.

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 increments of 100 shares of the stock to write covered calls
  2. In massively declining markets, the cash collected from premiums does not offset the losses of holding the stocks.

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.

Glossary

What is Hedging?

Hedging refers to buying an investment designed to reduce the risk of losses from another investment.

At Archimedes, our goal is to make investment literacy accessible and free for everyone.

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