How to Manage Risk During Market Downturns

While investing in the stock market is never for the faint of heart, there are times when the market can fall so drastically that even the most seasoned and experienced investor can lose his nerve. Sadly, the turbulent gyrations in the market cannot be avoided and often take everyone by surprise. In such circumstances, many investors will panic, liquidate their positions, and sock their money away in a CD or savings account. Who wants to expose their hard earned wealth to such risk? But if you want the benefits the stock market can offer, then you must also be willing to accept the risks. And for many the risks are just too great.

All is not lost, though, because there are some strategies that investors can follow to manage or eliminate risk. This strategy isn't a carefully guarded secret, but it does require using options, a financial tool that many investors consider too risky. Options do have a bad reputation, and that's unfortunate because using options gives each investor greater control over his portfolio.

So let's think about risk for a moment. If you own a car there is a chance that you might be in an accident, so to manage the risk of wrecking your car you buy car insurance. Similarly, there is always a risk you could get sick and face exorbitant medical bills, so to manage this contingency you buy health insurance. Now imagine someone who has most of his life savings invested in the stock market, and if his portfolio takes a turn for the worse he can lose thousands of dollars. In extreme cases, like Enron, investors can lose their entire life savings. Isn't it odd? Many Americans have ten of thousands of dollars invested in the stock market and it isn't insured. There's no guarantee that they will wake up the next day and be able to look forward to an easy retirement.

However, purchasing put options does allow investors to insure their investments. Briefly a put option allows the owner to sell 100 shares of stock at a specific price anytime before expiration. So if you own a stock that is currently trading for $50.00 a share and you purchase a six month $50.00 put option, then you have the right to sell your stock anytime in the next six months for $50.00. If your stock falls to $35.00 over the next few months, then you're still fine. You can exercise your option and sell your stock for $50.00. Market pullbacks are no longer much concern.

Let's look at it more concretely. Suppose you are still bullish on the energy sector and want to add a new stock to your portfolio, but have some concerns that there might be a strong correction in the near future. You don't want your investment to take a hit, but you also don't want to miss out on a great opportunity. In this circumstance, a "married" put -- buying a stock and, at the same time, buying a put contract -- is an ideal strategy. For instance, say you want to buy MEE (Massey Energy) which is currently trading at $31.58 a share. You purchase 100 shares and also purchase the April 08 $35.00 put contract for $610.00. Your total expenditure is $3768.00. So what did you "get" for this extra $610.00? You now have the right to sell your stock for $35.00 a share anytime between now and April. So what is your total risk on this investment? Since you have the right to sell your stock at $35.00 a share and your total expenditure was $3768.00, your risk is only $268.00, about 8% of your original investment. "Married" puts offer limited risk but unlimited reward.

Large institutions and hedge funds often buy puts on their investments to insure their gains. Imagine how much better your performance would be if all your losses were limited to the single digits? Although options do not trade on mutual funds, you can still purchase puts on an index to insure some of your investments in the event that market turns against you.

We all need to learn how to manage risk. The money we all save for education, our kids' future, or retirement is always in jeopardy of taking severe hits. Fortunately, there are ways we can protect our investments if we take just a little time to learn about options and option strategies.