Investing in the stock market is an inherently risky endeavor. Throughout history, the major stock indices have risen and fallen sharply over both short and long periods of time, leading some investors to avoid stocks due to their volatility.
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However, what if you could buy “stock insurance” that would effectively limit your portfolio losses should stocks fall sharply? By using derivatives and stop-loss orders, you effectively can.
What Are Derivatives and How Do They Work?
When most people hear the term derivatives, they think of the financial “weapons of mass destruction” that played a major role in the financial crisis that almost brought down our economy. While the irresponsible use of derivatives by large financial institutions was one of the causes of the financial crisis, derivatives at their core are conservative financial instruments designed to reduce investment risk and help insure against portfolio losses.
Broadly speaking, a derivative is a financial instrument that derives its value from the performance of one or more underlying assets. Typically, it is a contract between two parties that allows one party to limit the risk of outside events by passing this risk (for a fee) on to the other party. If you have a fixed-price contract with your gas or electric company, this is based on a derivative purchased by the utility that guarantees it can buy gas or electricity from its supplier at a certain price throughout the season.
There are two main types of derivatives available to investors to limit portfolio losses due to falling stock prices:
1. Futures — With a futures contract, the owner is obligated to buy an asset at a specified price on a certain date in the future. At the same time, the seller is obligated to sell the asset at this price on this date. A large and highly liquid market exists for futures contracts on the major stock indices like the Dow Jones Industrial Average, the S&P 500 and the Nasdaq 100. However, there is less of a futures market for specific stocks, at least for individual investors.
An example shows how a futures contract might help an investor limit portfolio losses. John owns an S&P 500 index fund that has appreciated considerably over the past couple of years as the stock market has risen. Given this sharp rise, he thinks the S&P 500 is due for a correction of at least 10 percent in the near future. A six-month futures contract would protect his portfolio should the index fall by up to 10 percent during this timeframe.
At the six-month mark, sure enough, the S&P 500 has fallen by 10 percent. While John’s index fund has lost 10 percent of its value, his futures contract allows him to buy back shares at the new lower price, resulting in a net loss of zero.
2. Options — With an options contract, the owner has the option to buy or sell an asset at a specified price on or before a certain date in the future. However, the owner is not obligated to buy or sell the asset. Call options give the owner the right to buy the asset at a set price — known as the “strike price” — while put options give the owner the right to sell the asset at a given strike price.
There is an active and liquid options contract market for individual stocks as well as stock indices. This makes it easier to acquire options on individual stocks than it is to acquire futures contracts on individual stocks. Let’s say that our hypothetical investor John owns 10,000 shares of a technology stock and wants to limit his potential future losses to no more than five percent. He could buy 100 put options (with each option good for 100 shares of stock) at a strike price that is five percent lower than the stock’s current price, with the options expiring six months out.
If the stock’s share price falls more than five percent during the next six months, John could sell his 10,000 shares at a price that is five percent lower than it was when he bought the options. As a result, John has effectively capped his loss at five percent. If the share price does not fall by at least five percent during the next six months, the options will simply expire worthless. John will be out the cost of these options.
Another Way to Limit Losses
In addition to derivatives, you can also limit portfolio losses due to falling stock prices by utilizing stop-loss orders. With this trading technique, your stock would automatically be sold if it drops to a pre-determined price that you specify ahead of time.
Let’s say that John owns 1,000 shares of a medical device company and he wants to cap his potential loss at five percent. He could place a stop-loss order with a stop price that is five percent lower than the current price. If the stock price falls by five percent, John’s shares would automatically be sold.
John could gain even more flexibility with a trailing stop-loss order. With this technique, the stop-loss order automatically adjusts when the stock price rises. So if the price of the medical device company rises after John places the initial order, the stop-loss order would adjust up — to five percent below the new higher price.
Yes, stock market investing is risky, but by utilizing derivatives and stop-loss orders, you can limit your potential portfolio losses. Deployed with care, these tools and techniques could provide you with more comfort and security when investing in the stock market — and possibly also help you sleep a little bit better at night.
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