Risk is a fundamental part of investing. It might be easiest to understand by using bonds as an example.
With bonds, the only investment that is considered to be risk free is short-term Treasury bills. For now, risk-free investing offers a return of 0.04%. At that rate, $1 million in retirement savings will provide $400 in income. Most investors don't have $1 million, so their actual return from safe investments would be even lower.
Because risk-free investments offer the smallest returns, pursuing higher income means accepting more risk. Treasury bills that mature in a year are an example of how income and risk can be increased.
This investment carries the risk that inflation could decrease the value of the principal invested in the bills. One-year T-bills are currently yielding about 0.1%, an amount that does not keep up with inflation. Investors are losing money, on an after-inflation basis, on all Treasurys with less than five years to maturity. This demonstrates that inflation risk might not be well understood by many investors because rational investors should not accept a nearly guaranteed loss in buying power.
To beat inflation, investors are forced to accept what bond investors call credit risk. This is the risk that the company issuing a bond might default. This risk is small for large companies but relatively high for smaller companies. Stock market investors call this type of risk "business risk," and they define it as the risk that a company could fail.
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In addition to risks associated with individual companies, stock market investors also face "systemic risk," which is the risk that the entire stock market will fall. Bond investors would consider something like the Federal Reserve increasing interest rates to be a systemic risk since it would decrease the value of all bonds in the system.
Risks that exist in the bond market are all found in the stock market. For stock market investors, the major risks are inflation, company-specific business risk and systemic risk. To manage inflation risk, many investors use hedges like gold or real estate, which should rise in value along with inflation. The other risks can be addressed with options.
Company-specific risks can be offset with put options. A put is an option that gives the buyer the right to sell 100 shares of stock at a predetermined price for a predetermined time. If you own a stock, you could buy a put to limit the potential downside.
Systemic risk could also be offset with put options. Buying a put on SPDR S&P 500 (NYSE: SPY) could provide a gain if the broad market sells off.
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The downside of buying puts for protection is that it can be expensive and could cost investors 3% to 5% a year, which decreases returns if prices don't fall. An alternative strategy is to sell covered calls. Assuming you are comfortable with the risks specific to the company, covered calls can generate income and protect against the risk of loss.
A call option gives the buyer the right to purchase 100 shares of a stock at the option's strike price for a certain amount of time. Selling a call could provide immediate income and protect against risk on the downside.
For example, if you own SPY, you could sell a call option that expires in about two months for about 1% of the value of SPY. This could be done six times a year and potentially add 6% a year to your returns. That amount could protect against systemic risk in the market and offset losses in a bear market.
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Action to Take --> Risks can never be completely eliminated, but they can also never be ignored. Using a covered call strategy could be the best way for many investors to protect themselves from investment risks while generating a level of income that is significantly greater than fixed-income investors can obtain.
This article was originally published at ProfitableTrading.com:
An Alternative Way to Protect Your Portfolio From Big Market Risks