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Protecting investments from steep stock slides

There are ways to minimize losses in a stock market downturn, and you can even profit from one. But each technique, from stop-loss orders to short sales to “put” options, has drawbacks.
/ Source: contributor

One day the stock market’s on a roll, the next it’s in a tailspin. And then there are days like today, when it appears all of Wall Street is in panic mode. Why? Blame it on credit crunch, soaring oil prices, bad news at Bank of America and Citigroup … you name it.

If only there were a way to buy insurance against the downturns — then you could watch your wealth ratchet up on the good days and laugh off the bad ones.

In fact, there are ways to minimize losses in a downturn. You can even profit from one. But each technique, from stop-loss orders to short sales to “put” options, has drawbacks as well as benefits. In clumsy hands they can make investing more nerve-wracking instead of less so.

While most of the basic techniques have been used by professional money managers for ages, the recent proliferation of exchange-traded funds has made it easier for small investors to do the same. ETFs own baskets of stocks the way mutual funds do. But instead of buying or redeeming shares with the fund company, you trade ETFs on the stock market, just like any other stock. This means ETFs can be used for loss-prevention strategies like stop-loss orders, short sales or options trading. You can’t do that with mutual funds.

Dow Diamonds, for example, are ETFs that own the 30 stocks in the Dow Jones industrial average. If you had a similar portfolio and worried the Dow was going to fall, you could buy a “put” option that would make money if the Dow dropped. Using a broad-based ETF like Diamonds — or Spyders, which track the Standard & Poor’s 500 — you could insure your entire portfolio against loss. (For a primer on ETF options, go to the Chicago Board Options Exchange Web site.)

All loss-prevention techniques involve some market timing, and even professionals have a devilish time forecasting the market’s peaks and valleys. But with that caution on the table, here’s a quick rundown on ways to safeguard an individual stock or an entire portfolio.

Stop-loss orders
The name says it: The investor places an order to automatically sell a block of shares in XYZ Corp. if the price falls to a pre-set level. If shares fall from $50 to $30 and you used a stop-loss order to sell at $45, you lose only $5 a share instead of $20.

The nice thing is you don’t have to be watching the market minute by minute to react to a downturn, since execution is automatic and the order can be put in hours, days or weeks in advance. Generally, the only expense is the commission you’d pay on any sale — plus taxes if you sell for more than you’d originally paid.

But there’s no guarantee you’ll get $45. If overnight news drove the price to $30 when the market opened in the morning, for example, you might get only $30, or even less.

To avoid this, you can place a stop-loss limit order, requiring that the sale be done only at the price you specify — $45. Unfortunately, you can’t be sure of finding a buyer at that price, so you might be stuck with the shares after all.

Short sales
This takes the rule “buy low, sell high” and simply reverses the order. You borrow shares from your broker, sell them at today’s price and hope to replace them with ones bought at a lower price later. By selling high and buying low you profit when prices fall. To do this you need a margin account with your broker.

Keep in mind that the strategy can backfire badly if prices go up instead of down. Imagine that you borrowed shares at $20 each, figuring they’d drop to $15 to give you a $5-a-share profit. Suppose the price instead soared to $30. You’d have to pay $30 to replace each share you’d borrowed and sold for $20 — you’d lose $10 a share.

With short sales you’re bucking the stock market’s long-term upward trend. Your potential loss is theoretically infinite, because there’s no telling how high the share price might go. That’s different from an ordinary “long” investment — when you buy shares and hold them. In that case your potential loss is limited to what you paid for the shares, since the price cannot fall below zero.

A put option gives its owner the right to sell a block of shares at a set price any time during the days, weeks or months before the option expires. The buyer pays a “premium” to acquire this right. On the other side of the deal is a trader who, in exchange for the premium payment, takes on the obligation of buying your shares at the price specified if you choose to “exercise” the option.

Imagine you paid a $100 premium for the right to sell 100 shares of XYZ Inc. at $10 each, or $1,000. If the stock fell to $8, you could exercise, which means buying 100 shares for $800 and, if you like, immediately selling them for $10 each, or $1,000. After subtracting the $100 you paid for the option, you’d make $100 from the falling share price.

The option owner is not obligated to exercise. If the price went up instead of down, you’d just let the options expire. You’d have spent $100 for insurance you didn’t need — like paying car insurance and not having a wreck.

If you owned 100 shares of XYZ, the put could be used to offset any loss in a downturn, and you’d still profit when the share prices rose.

The premium paid for options changes with market conditions. You’d pay more for the right to sell at $10 a share if stock is currently trading at $8 than if it’s trading at $12, since the $8 option could be exercised immediately for a $2 profit. Premiums tend to go up when share prices are volatile, or swinging more widely.

Obviously, the problem with puts is that it would cost too much to fully insure an entire portfolio all the time. But you could use inexpensive puts for partial insurance, limiting losses in a market meltdown. If the shares were trading at $10, a put allowing you to sell at $8 would be much cheaper than one allowing you to sell at $10.

These are futures contracts designed to match the behavior of underlying stock-market indexes such as the Standard & Poor’s 500 or Nasdaq 100. They were introduced a few years ago to serve small investors who could not afford the full-sized index futures contracts that professionals use for portfolio hedging and speculation. They are traded on the Chicago Mercantile Exchange.

A single S&P 500 e-mini contract could be used to hedge, or offset, losses in a diversified portfolio worth about $75,000. Every one-point change in the S&P 500 index causes the contract to gain or lose $50. And you don’t have to spend $75,000 to buy a contract — just a few thousand dollars in a margin account with your brokerage will do.

Unlike options, futures carry an obligation to trade at a set price on a given date. So instead of trading the e-mini futures contracts, many small investors trade options on those futures. If that sounds complicated, it is — e-minis take some studying up. Start at the CME's Web site  and click the Education tab. Also look at the CME's e-minis brochure.

This means spreading your eggs among many baskets by, for example, owning a variety of stocks and bonds. When some fall in price, others may rise.

The easiest way to diversify is to invest in mutual funds or broad-based exchange-traded funds. A given fund may own dozens of stocks — sometimes hundreds of them. And there are all sorts of funds, from “sector” funds that invest in certain industries, to ones specializing in foreign stocks, to “index” funds that try to match the performance of the entire market, or certain portions of it.

Do nothing
I’m not joking. If you’re diversified and have a long-term time horizon for your investments, time is on your side. Over most five-year periods in the past century, stock returns beat those of bonds and cash, such as bank savings. The longer the period, the more certain it is that a diversified portfolio of stocks will beat bonds and cash.

By simply hanging on through the downturns you can expect to do well — and you’ll avoid all the expense, hassle and worry that comes with so many of those fancier loss-prevention tricks.