Risk management is crucial for any would-be successful trader.
Sometimes traders focus too much on reward, but risk management strategies are the best way to increase the odds of generating positive returns over time, especially at times when the market as a whole turns against you.
With that in mind, the following article aims to describe 3 simple risk management tools that traders can use on a daily basis to protect their portfolios from experiencing large losses.
Tool #1: Stop-loss order
A stop-loss is a trade order that triggers a sell order (or buy order for short positions) once a pre-defined stop price is reached.
The purpose of this order is to cut losses quickly when the market price turns against you and they are one of the easiest and most popular risk management tools for beginners.
Once the stop price is reached, a market order is executed, allowing the trader to limit his losses or lock in his profits in cases when the position was already profitable.
There are multiple ways to use a stop-loss order to hedge against downturns. In most cases, traders determine the maximum amount they are willing to lose on a single trade and place the stop price based on that threshold.
On the other hand, other traders use support and resistance levels as the stop price, since a move above or below these levels could confirm that the latest trend is about to reverse.
That said, it is important to note that a stop-loss order does not guarantee that the selling price will be the exact stop price, especially during times of extreme volatility, due to the possibility of slippage.
Tool #2: Put options
A put option is a derivative that gives the holder the right – not the obligation – to sell a security at a certain price (known as the strike price) once the options contract expires.
These put options can be bought as a way to hedge your portfolio against a market downturn, as you will be to sell the instrument at the strike price regardless of what the market does.
Meanwhile, if the price of the security stays above the strike price once the contract expires, the trader can choose not to execute the options contract, which means that you can continue to enjoy any further upside.
That said, buying put options comes at a cost – the contract’s premium – and that cost increases when market volatility rises.
As an example, let’s say that you bought 100 AT&T (T) shares for $30 per share. You could hedge that position by buying a $30 put option expiring a month for now at say $0.4 for a total of $40 per contract (each contract is comprised of 100 shares).
Your position would be worth $3,000 and hedging it against a downturn would cost $40 or 1.3% of your position. If the price of the shares were to move 1.3% or higher during that month you would earn the difference between your realized gains and the $40 you paid for the put option.
Tool #3 – Buying uncorrelated or negatively correlated assets
The statistical correlation of an asset is measured by the strength of the relationship between its performance and that of another asset.
For example, an asset with a correlation of 1 with, say, the S&P 500 index is one that increases 1% when the index increases 1%.
From the perspective of risk management, having a portfolio that is mostly comprised of highly correlated assets guarantees that when one of the assets goes down, the entire portfolio will go down as well.
To mitigate this risk, traders often incorporate a percentage of uncorrelated or negatively correlated instruments.
Uncorrelated instruments are those that have a correlation index of 0.3 or lower. Meanwhile, negatively correlated instruments have a minus 0.7 correlation index or higher – compared to the portfolio’s top components.
One example of this would be to buy CBOE SPX Volatility Index (VIX) futures to hedge against downturns in the S&P 500 index.
VIX futures move inversely from the S&P 500 index, as they have a negative correlation with the index.
When the S&P 500 goes down sharply, VIX futures will rise. This would help in cushioning the impact of the index’s downturn in the value of the portfolio.
That is, of course, an overly simplistic example of how this risk management strategy works, but it does illustrate how it can be used to mitigate your losses during periods of high downside volatility.
Although there is no way that you can fully protect your portfolio from experiencing a loss – at least in a cost-efficient way – you can use some or all of the tools mentioned above to keep your losses in check, which will help you in improving your returns over time.