In the world of investing, there is a relationship between risk and reward. Investing in stocks can produce some of the best long term returns available, but investing in the stock market is not without risk, either.
In the days past of higher interest rates, risk adverse investors could get reasonable returns from risk-free or low-risk investments, like Treasury bonds and FDIC-insured certificates of deposit.
Even though interest rates have risen somewhat this year, they are still very low, and the low rates have forced a lot of income oriented investors into the stock market and dividend paying stocks.
Bonds can have some volatility between the time they are purchased and the date they mature, but conservative investors have the peace of mind knowing that unless the issuer defaults, they’ll get their money back when the bond or CD matures.
Now that many investors have fled bonds into dividend paying stocks, some are concerned about how they can protect their holdings in the event of a major market decline.
Every type of portfolio protection available has its advantages and disadvantages. There is no way to remove all of the risk and still have the potential for market type returns.
Stop orders are one form of protection. Say you own 100 shares of XYZ stock that you bought at $20 and it’s up to $30 per share. You can place an open stop order to sell your XYZ at $25 per share to protect some of your profit, and if XYZ trades at $25, your stop order will be executed.
Stop orders work most of the time. The main disadvantage is that the stock market is not open 24 hours per day. XYZ could close one day at $30 and open the next day at $15. If that’s the case, your stop order would be executed at $15 and you would not have the protection you had hoped for.
Unusual market events like the “flash crash” in May 2010, when the Dow dropped about 1,000 points in a matter of minutes, then recovered, can trigger stop orders and create losses.
Put options provide protection, but cost money just like buying insurance on your house or car. The purchase of put options can be financed through the sale of call options.
This strategy is known as a “no-cost” collar and can provide better protection during times of uncertainty. The collar can limit your potential return, but can also provide superior risk control.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information on his money management service can be found at his blog at www.sellacalloption.com or by calling 775-657-8065. Past performance does not guarantee future results. Consult your financial adviser before purchasing any security.