Saturday, February 7, 2015

Stock Insurace: 3 Strategies to Limit Stock Losses

People protect their largest assets by buying insurance on their home, cars, expensive jewelry and even their lives. Much the same way, investors can use derivative securities to effectively buy insurance on their individual holdings or on their portfolio as a whole. Although derivative securities may seem risky, when used properly they function in exactly the opposite way – to reduce risk and insure against loss. One can also use order-management strategies such as a stop loss order. (For more, see: Are My Investments Insured Against Loss?)
Using Futures to Hedge
Futures are derivative contracts that obligate the owner to purchase the underlying asset at a specified fixed price and at a specified future date. Likewise, the seller of a futures contract has the obligation to deliver the underlying asset at that price and time. Of course, in the majority of cases traders close out their positions buy selling a long position or buying back a short position prior to expiration as not to take delivery.
Although there isn't much of a market in futures on individual stocks, there is a large and highly liquid market for stock index futures. If an investor's portfolio largely resembles an existing equity index such as the S&P 500, Nasdaq 100 or Dow Jones Industrial Average, or if they are passively invested in an indexed strategy they can use futures contracts to insure themselves against a drop in market value.
Suppose an investor owns a portfolio that consists of a large amount of SPDR S&P 500 ETF (SPY), and she anticipates a decline of at least 10-15% in the price of the index at some point in the next six months, but she does not want to sell her position outright (perhaps due to tax considerations, to avoid transaction costs, or because the strategy prohibits holding large cash positions etc.). She can sell enough futures contracts that expire in six months to cover her portfolio value.
In our example, four months later the S&P 500 declines 15%. Her portfolio value has lost 15% of its value, but the futures contracts that she sold have also declined by the same amount. She can then buy back those futures to cover at the lower price, and her resulting loss is net zero. If her portfolio was left unhedged, she would be down the full 15%. In this hypothetical example, the hedge fully protected the portfolio against a decline and she preserved the value of her portfolio despite a significant decline in the market of 15 percent. But, if the market had risen, the portfolio's gains would have been exactly offset by losses on the futures contracts. If the market were to rise instead of fall, our investor would have had to consider removing her hedge by buying back the short futures contracts at a higher level. (For more, see: A Beginner's Guide To Hedging.)
Using Options to Hedge
Options are derivative contracts that give the owner the right, but not the obligation, to buy or sell the underlying asset at a specified price, at or before a specified future date. Owning call options gives the right to buy the underlying asset and owning put options gives the right to sell it.
There is an active and liquid market in stock indexes and also on many individual stocks. Listed options can therefore provide insurance on portfolios that deviate from a benchmark or index.
The Protective Put
Since put options give the owner the right to sell the underlying asset at a specified price, they can also be used as an insurance policy on that asset. Suppose our investor also has 50,000 shares of Apple, Inc. stock (AAPL) and although it has done very well for her, she is concerned that it might decline from its recent highs in the next few months and wants to ensure that she can lose no more than 10% from its current price. She may purchase 500 put options (each listed option represents 100 shares of the underlying stock) with a strike price 10% below the current price, and with an expiration date in three months time.
If the price were to fall more than 10%, she would still retain the right to sell her shares at that fixed price, 10% lower than where it is now, effectively capping out her potential loss. She could also sell her put options back in the market at a profit which would offset some of her losses in the stock.
If, on the other hand, shares of Apple continued to rise, her options would expire worthless and all she would have lost is the premium, or price, of the put options. (For more, see: Risk Management And Options - Hedging With Options.)
Order Management Strategies
Not everybody has access or the desire to trade derivatives, even if it is intended to hedge against loss. Some brokerage firms do not offer derivatives trading, and their use may be restricted in certain types of accounts. Alternatively, an investor's holdings might not have a market for an adequate derivative instrument to be used. In these cases, losses can still be mitigated using order management strategies like stop-loss orders and stop-limit orders. With derivative hedging the traders owns the underlying asset, whereas order management strategies set up orders to sell the underlying stock given some triggering event, which means the end of the hedge.
Stop-Loss Orders
A stop-loss order is a specific type of order that can be placed with one's broker. In essence, it is an order to sell triggered when the price of the stock in question falls to a certain price specified by the investor. Once the stop price is reached, the order can be executed as either a market or a limit order. Our investor owns 1,000 shares of a foreign biotech company in her portfolio with no listed options. The company is issuing a report on it's latest drug trials and a bad result could cause the share price to drop significantly. She initiates a stop-loss limit order with a stop price 10% lower than the current price and the same limit price. If the stock were to drop 10%, the stop would be triggered and her shares offered in the market at that price. If the stock did not fall that far, or instead rose, the order would not be triggered.
Some variations on the stop-loss order include trailing stop-loss orders which continually re-adjust when the price of the stock increases. In our example, if our investor had initiated a trailing stop-loss order at 10% below the current price and the stock then rose in value, the stop-loss order would automatically re-adjust higher to 10% below that new price. It would then be triggered if the stock fell 10% from that higher level. Trailing stop-loss orders can generally be set as a percentage below the current price or a set dollar amount, and they are useful to preserve gains while managing potential downside moves. (For more, see: Trailing-Stop Techniques.)
The Bottom Line
The same way that people protect their physical assets with insurance – such as their home, car or expensive jewelry – people can also protect their financial assets from adverse down moves using derivative securities or order management techniques. The one thing to keep in mind is that just like home or auto insurance, financial insurance comes at some cost – albeit a cost that many are willing to pay.

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