Tomorrow (Thursday), the Federal Open Market Committee - the Fed's monetary policy committee - will meet to discuss whether or not to raise interest rates for the first time in roughly nine years.
The recent sell-off has cast some doubt on what they might do - raise rates and hope for the best, or keep rates near historic lows through the end of the year to let the market find its legs.
But no matter what the Fed decides, you've got to stay in the markets. I've said before that one of the costliest mistakes you can make as an investor is to sit on the sidelines. If you want to make money, you have to be in the markets. So if you want to win - no matter what the central banks do, and no matter what the markets do - you have to keep playing the game.
Sometimes, that's easier said than done, I'll admit. But the easiest way to stay in the markets in tough times is to make sure you've got a sound risk management strategy.
In fact, when it comes to making consistent money in the markets, controlling your risk in your trades - and managing your losses - is just as important as anything else you do as a trader.
Today, I'm going to show you why options are the best risk management strategy in the markets - and four concrete ways you can use them to protect your investments and manage your risk.
I have shown you how to make good, consistent money with options, but did you know they were created just as much as a way to control risk as they were to engineer profits?
The four ways to use options as a risk management strategy are as follows:
- Owning options versus owning a stock
- Using options to hedge a stock you already own
- Using options to hedge other options
- Using options to hedge your entire portfolio
Owning Options vs. Owning a Stock
The biggest risk faced by investors is price risk - that's the risk that your investments will decline in value. Price risk can be mitigated by diversifying your portfolio or by employing a variety of hedging techniques.
But the only way to truly lower your price risk is to put less of your capital at risk in the first place.
And the best way to do that is to buy options instead of buying stock.
Options are great risk management strategy in that you can control 100 shares of a stock priced at $100 for far less with the purchase of a two-month-out expiration $100 call option.
The stock would cost you $100 times 100 shares, or $10,000.
The option, priced at $7, would only cost you $700 (one contract grants rights to 100 shares multiplied by the $7.00 cost per contract = $700).
It is unlikely the stock ever gets delisted or stops trading, but technically your risk is that the stock goes down to $0 in price, which would result in you losing the full $10,000.
Meanwhile, the most you could lose on the option is your initial $700 investment, which is considerably less.
Using Options to Hedge a Stock You Already Own
Everyone that owns a stock knows that when the stock goes lower in price from what you bought it for, the stock is losing value, resulting in your account value decreasing. You don't actually realize the loss until and if you sell the stock at any lower price than you bought it.
Another great way to use options to lower your risk is to buy put options to offset potential losses on a stock that you already own.
Let's say you own a stock for $70 per share. Let's say you learned that having a 10% loss amount as a way to minimize risk is a good way to go. This means you would have in place a stop loss order at $63 per share (10% of $70 is $7.00 subtracted from the $70 = $63).
This is a time-tested strategy that works to minimize your risk... until a report about the company and some accounting irregularities is released overnight, causing the stock to open at $35 the following day.
Your stop order hits at that $35 mark rather than at your targeted $63 level, causing a considerable loss to your account - a 50% loss, in fact. Not a great way to start your day.
You could have bought a put option as a way to protect against these kinds of catastrophic losses.
Here, let me show you.
As we've talked about, a put option gives the buyer the right to sell a stock at a specific price on or before a specific date.
So if you bought the $70 put to hedge your $70 stock, you would have the right to sell 100 shares of that stock back to the market for $70 no matter where the stock is currently trading on or before the expiration date.
Sure, the option could expire and the cost of the put - insurance, if you will - would be lost, (unless you sold the put for a gain). But the loss on the put contract would be much easier to take than the losses on an unhedged stock position.
Many traders see the price of put options as simply the cost of doing business, especially on expensive or volatile stock positions.
Using Options to Hedge Other Options
If you've been following along with Power Profit Trades, you're already familiar with this technique... this is exactly what we're doing when we execute a "loophole trade."
Options can be bought as a proxy way of owning the stock. Instead of buying shares of Caterpillar Inc. (NYSE: CAT) in anticipation of the stock going higher, you could buy a call option. Here is an example where CAT is trading at $72.68.
Let's say you bought a slightly In the Money (ITM) call option (in this case, the October 2015 $70 calls). Its current mid-price shows it could be bought for $3.88, or $388 for one contract.
But let's say your risk management plan dictates that you aren't to spend more than $300 per trade. You would not be able to purchase that contract because it would cause you to break your money management rules - and you're not going to do that, are you?
That's where the loophole trade comes in. You can simultaneously sell a call option against the call option you want to buy.
When you buy one call option for a specific expiration date and sell a call option for the same expiration, but with a higher strike price, you are creating what is called a call debit spread. It is also known as a bull call spread.
It is an option strategy used to reduce the risk from just buying a straight long call option.
To buy the October 2015 Week 2 $70 call would cost $3.88 for the one contract, or $388. But when you also sell the October 2015 Week 2 $75 call, you bring in $1.23 (mid-price), or $123.
The cost to buy the call option that you've targeted is now offset by the premium of the call option you sold, or $1.23.
So your out-of-pocket cost would go from $388 to $265 ($388 - $123 = $265).
This is a savings of almost 32% ($1.23/$3.88 = 31.7%).
Since cost is risk, you have reduced your risk by close to a third of the cost of just buying the call.
Using Options to Hedge Your Portfolio
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Those of you who have been investing for a number of years probably own at least a handful of stocks. If you're saving for retirement, your financial advisor has no doubt put you in an array of indexes and mutual funds to build your wealth.
That's a fine "buy-and-hold" strategy, but it means that when the markets eventually move lower - and they will - your entire portfolio is at risk of taking a tremendous hit.
Now, how well you're diversified may help with risk in that some sectors may not drop as hard as others. Some stocks may hold up well compared to others. Still others may rise if they aren't exposed to whatever contagion is plaguing the markets. But it's hard - if not impossible - to predict which stocks are going to withstand the next market crash.
But there's one last way you can use options to manage your risk, and that's to buy puts on a broader index that includes the stocks in your portfolio.
If you're invested in the markets, your best bet is SPDR S&P 500 ETF (NYSE Arca: SPY), an exchange-traded fund that tracks the S&P 500.
If you see a market decline coming our way - despite what the Fed says tomorrow - you could consider buying SPY puts, say At the Money (ATM) or slightly Out of the Money (OTM), commensurate to the dollar amount of shares you own.
For example, right now, SPY is trading around $198.50. To properly hedge a $20,000 stock portfolio, you'd need to buy one put option. That would give you control of 100 shares, valued at $19,850.
When the market drops, your puts should increase to the point that you're roughly breakeven on your portfolio value, or should at least reduce the value of your loss (remember, it is not an actual loss until you sell your stock).
Of course, with the purchase of puts as insurance, you run the risk of not having to cash in your insurance, or the puts could decrease in value with a run up in the markets. This is true with all insurance though, isn't it? You buy insurance just in case... the same is true when you're hedging with options.
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What Should You Do If Profits Come Early? With options trading, even the smallest move in the underlying stock can result in explosive profits. Sometimes those profits come in just a single day. This strategy will ensure you book profits even with today's fast-moving markets...
About the Author
Tom Gentile, options trading specialist for Money Map Press, is widely known as America's No. 1 Pattern Trader thanks to his nearly 30 years of experience spotting lucrative patterns in options trading. Tom has taught over 300,000 traders his option trading secrets in a variety of settings, including seminars and workshops. He's also a bestselling author of eight books and training courses.