When you invest your hard-earned money in the stock market, you stand a good chance of getting a return that’s a whole lot better than you can expect from the interest on a savings account or a CD. Stocks and most other securities are not insured the way bank deposits are, so you might lose money. Downside protection reduces your risk.
Hedging is the most straightforward type of downside protection. Imagine you bought 100 shares of XY Company and the stock is trading for $32 per share. You can hedge your investment in XY Company by purchasing a put option for 100 shares of the stock. Put options are contracts giving you the right to sell the stock at a guaranteed “strike price” for a limited period of time. Let’s say you buy a put option to protect your XY Company investment and the strike price is $30 per share. If the market price drops below $30, you can still sell your shares for $30 until the day the put option contract expires. If the price goes up, you let the option expire and all you lose is the premium you paid to buy the put option.
Hedging an investment with put options is a short-term strategy. That’s because options contracts are normally good for only a few months before they expire. If you plan on holding shares for just a few months, put options are an excellent way to invest with downside protection. This is also a helpful strategy if you own shares that you’ve held for a long time and that have risen in price. If you are not quite ready to sell the stock but you want to protect the gains you’ve made, you can use put options for this purpose at the cost of a small premium.
Another strategy for investing with downside protection is to write a covered call option. This means you write, or sell, a call option contract with a strike price that’s higher than the current market price. The purchaser of the call contract has the right to buy the shares from you at the strike price. If the price declines or does not go up to the strike price before the option expires, you keep the premium the purchaser paid. The premium provides some downside protection by offsetting part of any drop in the stock price. One negative feature of covered calls as downside protection is that you give up the possibility of making more money if the stock price goes above the strike price. If that happens, the holder of the contract you wrote will exercise the option and you have to sell him your shares at the strike price. Covered calls are a sophisticated strategy for reducing downside risk usually employed by experienced options traders.
A stop-loss order is an instruction to your broker to sell stock or another security if the price falls below a specified level. This is not useful for the investor who buys and holds shares for months or years and isn’t concerned about short-term changes in the market. However, stop-loss orders provide effective downside protection for momentum traders who buy shares and then sell them the same day or within a few days. Momentum traders try to anticipate short-term price fluctuations and operate on small profit margins. An unexpected dip in a stock price can make a big difference. The use of stop-loss orders insures a quick response to such surprises and keeps potential losses to a minimum.