Needless to say, over the last fifteen years we have seen market movements that have been quite volatile. Events such as Long-Term Capital Management, the Asian Crisis, dot.com bubble, mortgage bubble, and the European crisis can make one reconsider if the markets are the right place for us. Buy and hold strategies of the past seem as antiquated as the days when we actually had to get off of the couch to change the television channel. Yes, at one time that was necessary.
In these current markets you need to have protection. You would not drive that valuable automobile without insurance, but why do so many people insist on doing it? The problem is a lack of real knowledge of the subject. The strategy we feel is most effective is the use of stock options to hedge your portfolio. Yes, you can always use protective stop orders, but that will always lead to a loss. You could also employ the use of short indexes, but do they really apply to your portfolio? There may be a correlation, but not always in sync with your strategies. You need to have a coherent plan in place whenever you enter a new position. Using an ad hoc approach will usually lead to disaster. Here is an example of how we feel you should safeguard yourself.
Trade Example
You have scanned dozens of charts and feel that ABC company is primed for a big move. You buy 1000 shares at $13.00 then put a protective stop loss order at $11.00. After you get out of your umpteenth meeting of day you check the markets and you hear word of something called a “flash crash”. Well, all of your positions in your portfolio have stopped out for the day. Unfortunately, by the end of trading most of them are back to above stop levels. But it’s too late. There is another insidious situation that can occur with stop loss orders. You have your stop loss order at $45 and the market gaps down at the open and your order fills at $37 then ends the day at $44. I have seen this occur in hundreds of situations. Here is a way to remedy these occurrences.
When you go long, or short a stock, you need to take a proactive approach and hedge yourself with either a long call or put. If your stock does sell off in a long position, you leave yourself alternatives. You can sell the option at a profit, and close the stock position for an overall slight loss. You can also continue to hold the stock position until it regains its losses. Either way, you don’t have to take that loss you would have in previous trades. Conversely, if the stock runs, you can trade up on your option and keep the unlimited gains scenario in place. You are still driving that Porsche. Protecting yourself through insurance has always come at a price. But just consider the alternatives.
