Risk Management 101

With the current bias to the downside, you need to have some risk management in place to avoid watching your trading capital disappear. This could be via mental or physical stop-loss orders. Or, if you want to avoid selling into a negative market, you could write call options on some of your stocks to generate some premium income and help reduce the average cost of a position.

However, the uncertainties make more downside moves in stocks likely in the near term and heading into 2009, which is turning out to be filled with uncertainty. We are clearly nervous, as a market bottom has yet to be established and this is where the risk is.

Another strategy you can employ is the use of put options as a downside hedge. I have discussed this in the past, but will reintroduce the strategy again. An option is a binding contract established between the two participants on the opposite side of a trade (i.e. the buyer and seller). A purchaser of a put option buys the right, but not the obligation, to sell the underlying instrument.

Establishing put options makes sense to me and should to you. The fact is that investment assets are valuables, probably having the first or second largest value after your home. By the time you retire, the value of your investment assets would be probably far in excess of your home value. So, this makes protecting your investment assets that much more critical, so you can enjoy that retirement.

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You can establish put hedges for a single stock or a basket of stocks, where buying put options to match each stock would be both economically infeasible, as well as improbable due to the limited selection of put options. If you own a basket of stocks, look for a stock index option that has a high statistical correlation with your particular group of stocks.

Holders of technology stocks, for instance, could buy put options on the NASDAQ-100 Index — representing the 100 major technology stocks trading on NASDAQ. Just flash back and think about how handy these index put options would have been when the NASDAQ Composite was trading at over 5,132 in March 2000, just before its fall into the abyss.

The mechanics of buying put options on a stock index are quite straightforward and no different from put options on an underlying stock. There are only a few things to keep in mind. Remember that index options are cash settled and you must find an index option that best matches the group of stocks to protect. Once you find the appropriate index option, the next step is to match the value of your investment portfolio as closely as possible with a corresponding number of put options that, when combined, approximates the value of your investment assets.

Take a look at the CBOE web site for more info on the options traded.