There is no reward without risk, and this is especially true when it comes to investing. In fact, it would appear that the goldilocks period for small and large investors is coming to an end – just look at the volatility in the market last week.
But what if you don’t have the resources of a billion-dollar hedge fund? Well, you might not have the research capability or be able to hedge every trade you make but this doesn’t mean that you have to live with an unnecessary level of risk in your portfolio.
That’s right, the little guy is not powerless when dealing with the ups and downs of the market. In fact, this not only extends to investing but also to your business. For example, if you trade in used cars, you can even get a car dealer bond to limit the exposure of your business.
With that in mind, here are three ways to reduce risk in your portfolio.
1. Put Options
While stocks have mostly been going up lately, they can also go down. Just look at the recent 800-point sell-off. In fact, things can get so bad that some stocks have even dropped to almost $0 – even blue chips have faced this issue, just think of Enron, WorldCom, or even the recent accounting scandal surrounding General Electric.
One way to shield yourself from this risk, even at its extremes, is to buy put options on the shares you own. These options allow you to sell your shares at a predetermined price – assuming the option has yet to expire.
Just keep in mind that these options do not come for free. As such, you will need to balance the cost of the options with the amount you have at risk, meaning that some trades aren’t worth hedging via put options.
How do put options work? Let’s say you are eyeing 100 shares of a stock which is currently trading at $100. You could buy a put option which would allow you to sell the shares at $95 – limiting your loss to five percent.
In general, a put option will cost around one-tenth of one percent of the value of the shares. So, in this case, you would spend roughly $100 to cover a five percent loss on a $10,000 trade. Granted, you won’t be able to exercise the trade if the shares only fall by four percent. But in this scenario, you will be able to narrow your loss if the shares hit the strike price before the options expire.
This brings up a key point when acquiring options – always check the expiration date. While shorter-term options might cost less, you will want to make sure you are covered for the period you want to hold the shares in question and as such the option period should cover this.
2. Betting on Futures
You might not think that betting would be a way to reduce risk, but futures contracts could offer you the hedge you need to protect yourself. While these contracts used to only focus on physical commodities they have since been extended to financial products such as stocks, bonds, and even exchanges.
As such, you can use futures contracts as a hedge on the overall direction of the S&P 500 and interest rates among other commonly traded items. In fact, hedge funds commonly use futures to limit their risk, so why shouldn’t you?
3. Buy the Competition
Granted, this approach is not without controversy as some would question why you are investing in a competitor if you believe in the target company. But the reality is that the real economy has its ups and downs and betting on a competitor to move in the opposite direction of your primary target might be a good way to decrease the risk in your overall portfolio.
For example, if you owned part of a major airline, you might want to consider acquiring a small amount in their competitor. The idea behind this is to recognize the operational risks of Company A are not the same as those in Company B, even when they are in the same industry.
Conclusion
No investment is without risk and even while the markets have been very kind to investors for the past three years, there is no guarantee that the environment will continue to be so accommodating going forward. As such, look for ways to reduce risk in your portfolio as this will help you to come out on top when the market takes a turn for the worse.
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