Two Ways High Performing Investment Portfolios Guard Against Losses
Are stocks overbought, or does the bull market have more to run? Sound arguments can be made for either side.
On the side that forecasts more stock market gains, they may point to earnings expectations. This makes sense since fewer pandemic-related restrictions are now leading to more business activity. Activity means earnings increases which normally equates to the stock market rising. On the bearish side, those that think the market is pricey and too risky may argue that interest rates have begun to move up from their historic lows. Higher rates add to the cost of doing business and serve to reduce consumer purchases. Additionally, stocks are an alternative for income investors that have left the bond market in hopes of a higher yield. As higher bond yields return, they may shed their stock market positions and return to the fixed income market.
Both bullish arguments and bearish positions have merit. This leaves investors with the decision to either leave a still booming stock market and possibly miss out on returns in exchange for near-zero interest or the potential for double-digit gains in equities. The double-digit returns, of course, may be negative double-digit to investors. It is basic physics that the higher something climbs, the further it has to fall. Both stocks and bonds are near priced near historic highs. This means they both have more potential downside than ever before.
Capturing Upside and Limiting Downside
Stocks have not exhibited any real weakness since late March 2020. The trend is still rapidly upward. People are putting more and more money in equities. The more money that goes in, the less money that can be used to help drive up prices later. And the more money that may run for cover later when an eventual selloff occurs.
Investors that expect an inevitable selloff will one day occur, but also that the market has more upside, could consider practicing a little defense. In today’s point-and-shoot world of stock trading both online and by phone app, many individuals don’t take the time to protect themselves from major losses. With the market continuously going up and quickly erasing any downward moves, investors have been rewarded for ignoring the fundamentals of risk management. The truth is, we don’t know when the big slide (or slow march) down will occur, but we do know we are closer to it than we were yesterday.
The two most basic methods for an individual to feel confident that their portfolio can still capture gains, without too much risk on the downside, are placing stop losses on their positions or buying puts. The stop losses cost the portfolio owner the erosion down to the Stop (sell price) only if hit. The cost of the Put is upfront and known even if it is never exercised which would be the case if the stock continued to perform well through the Put option’s expiration.
Using Stop Loss Orders
A stop-loss order gets you out of a stock you’re long when the price starts falling. If you’re short, a stop-loss buy order can be used. There are several types of stops you may use. A Hard Stop is when you set a fixed price that, if reached, triggers a market sell order. For example, you own “Company A” stock at $4.25; it is now trading at $7. Over the past few weeks, it has dropped to $6.50 several times but seems to have firm support there. To protect yourself if the stock should drop below that and keep going, you could set a hard stop a little below the $6.50 price. For example, If you set this stop loss at $6.30, an at-market sell order will be triggered when it hits $6.30. In a world of commission-free trades, you may wish to quickly get back in at a lower price if it should drop considerably.
A Trailing Stop is a little different; it moves up with the stock price in a long position and down with the price in a short position. The order is spread to the price in terms of dollars or a percent difference. Using the example from above, if you set a trailing stop of 10% and Company A stock rises from $7.00 to $9.00, the trailing stop will move from the original $7 less $0.70 ($6.30) to $9 less $0.90 $8.10). The idea is more profit is captured when the stock does turn downward. A set dollar amount, rather than a percentage, can also be used for trailing stops.
Proponents of stop losses take comfort in their ability to protect the position from rapidly changing markets. Opponents could argue that both hard and trailing stops make temporary losses permanent. For an investor who is always monitoring their account and can trust their decision-making as moves unfold, they may feel a stop loss is not for them; they can stop losses on their own. Whether an investor uses them or not, once in a position, pre-planning various scenarios and actions you could take is critical to managing downside risk.
At the end of the day, if you are going to have continued success as an investor, you have to be confident in your strategy. This means carrying through with your plan. The advantage of stop-loss orders is that they can help you stay on track and prevent your judgment from getting clouded with emotion.
Put Option
The S&P 500 declined in one out of every four years between 1926 and 2009. Then the “Great Financial Crisis” of 2008 cleared the way for years of stock market growth leading us to today’s heights. That is a very long barely interrupted growth trendline, historically. The most basic way for an investor to protect their upside gains is to take profits. One problem with this is what if the stock is still the best place for your money. After all, selling the stock means you have to do something else with the proceeds. When this is the case, locking in some of your gains, and holding the stock, can be done using the options market.
A common strategy is to buy a Put Option (a Put). This gives the holder the option of being able to sell stock at a certain price at a specific date in the future.
For example, you own 100 shares of “Company B.” It has risen by 80% in a single year and now trades at $100. All the analysts covering the stock have price targets well in excess of $100, and the industry is experiencing a boom for the foreseeable future. But, who knows, some of these positives may already be built-in, and the bigger picture economy is questionable. Or there could be a black swan event. To protect your profits, you could buy a Put on Company B with an expiration date six months into the future, and at a strike price (sale price) of $105, (slightly in the money). This option’s market value will fluctuate as you hold it with expectations, time to expiration, and changes in the equities value. But, for the example, let’s say the option costs $600 ($6 per share). You now have the right (contractual ability) to sell 100 shares of Company B at $105.
If the stock drops to $90, the value of the Put will have risen significantly. At this point, you can sell the option for a profit to offset the decline in the stock price. Options do have expiration dates, at which time the contract for the counterparty to honor your ability to exercise the Put expires. It becomes an unused “insurance policy.”
Take-Away
With stocks and bonds trading at historic highs, being in either the equity or fixed income markets represents a greater potential for loss. There are tools and strategies which can protect you from extreme losses.
Getting completely out of any investment may not be the best plan. After all, everything has a cost, even doing nothing. Just think about the investors that stepped aside and went into cash during the first half of 2020, thinking, “it isn’t wise to be long during a pandemic.” They are likely worse off than if they had invested in a diversified mix of large and small-cap stocks. They didn’t get hurt by stepping aside, but they missed a huge run-up.
Investors that believe there is likely plenty of upside to a market index or particular stocks can still participate and capture much of it if it occurs. This, too, has a cost, but that cost serves as insurance against extreme losses.
Your broker can provide you with more detailed descriptions and various reasons when these strategies and other possible risk-limiting measures benefit your account. Each trading platform works differently, if you have questions you should contact a representative of your broker.
Paul Hoffman
Managing Editor, Channelchek
Suggested Reading:
Money Supply Drives Stock Market Performance
Can Small Investors Compete with Wall Street?
Seeking Alpha’s Paywall Causes Frustration
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