10 Ways to Minimize Losses in High Level Investing - dummies

10 Ways to Minimize Losses in High Level Investing

By Paul Mladjenovic

Even the legendary investing and speculating pros have failures and losses. The key is that all these people learned from what they did and modified their approaches going forward. Here are ten aspects of losses, either helping you minimize them or suggesting what to do if you have them.

Use stop-loss orders

Have your profits run, but limit your losses. This age-old advice may be a cliché, but it’s the quintessential grand strategy.

In today’s marketplace, limiting your losses is easy to do thanks to technology. Considering how crazy and volatile the world is, the stop-loss order should be a ready weapon in your investing and speculating arsenal. The trick is knowing when to place a stop-loss order, how long it should be in effect, and how far to place the stop loss-order from the stock’s (or exchange-traded fund’s) market price.

You put a stop-loss order on a holding in your portfolio (such as a stock or ETF) to limit the downside risk of the holding without limiting the upside potential.

Employ trailing stops

The trailing stop is a stop-loss order that essentially trails the stock price like a giant tail as the stock price zigzags upward. The moment the stock reverses and falls, the trailing stop-loss order stays put at the most recent level it reached. When and if the stock does hit that stop-loss price level, the trailing stop turns into a market order and the stock will be sold. At that point, you’ve avoided further losses.

Go against the grain

When everybody and their uncle are ebullient about the stock market and the bulls-to-bears ratio is similar to the ratio of Red Sox fans to Yankees fans at Fenway Park, then it’s time to be a contrarian — a cautious one.

Starting to step away from a party that is overdue to end is a good way to avoid losses. Sure, you might miss a little more upside, but no one gets hurt taking a profit by selling or by using other loss-limiting strategies.

Have a hedging strategy

Having a hedging strategy after the crash is like closing the barn door after the horses escaped. The best time to consider a hedging strategy is before a major market reversal. A hedging strategy is basically knowing (and doing) what is necessary to preserve gains or simply to limit the downside.

A hedging strategy differs depending on the duration of the expected fall. For corrections, you consider hedging by buying put options, for example. For bear markets, you look to sell and be in cash.

Hold cash reserves

Opportunities happen constantly — risks show up to derail or delay the best plans — but the prepared investor always has cash on the sidelines. Some extra cash is like a secret weapon; it’s also a saving grace when your positions are down, and you need money for some unforeseen expense.

Sell and switch

When your stock is down, can you do a fancy two-step that can save you on taxes and set you up for a profitable rebound? Keep track of your unrealized gains and losses and see whether there are opportunities for tax benefits, given what is happening in your portfolio. Maybe you have an opportunity to sell a losing position in your portfolio to book a capital loss. Realized capital losses are generally tax-deductible (check with your tax advisor to be sure).

You can play the rebound in a variety of ways, but make sure that the tax loss makes sense in your situation and that you did your due diligence regarding the potential rebound of the stock or the sector it’s in. Discuss your personal tax situation with your tax advisor.

Diversify with alternatives

Keep in mind that as an investor, even if you have limited capital, you live in a time where there are many strategies and investment alternatives. When you have a stock in mind that you’ll be investing in, you should list or research the alternatives that could accompany or augment your investment choice and help you limit or even reverse a potential loss.

Using leveraged ETFs is a good example of this approach. A leveraged ETF is a speculative vehicle that seeks to emulate double or even triple the move of the underlying asset.

Leveraged ETFs are a form of speculating. They may magnify gains when you’re right, but they can magnify losses if you’re wrong.

Consider the zero-cost collar

You have a stock that has done well, but you’re worried. The stock may have some upside, but the downside risk seems to be growing. You don’t want to sell the stock because the gain is sizable (and taxable!), but the short term worries you. Can you protect your stock from a potential correction without needing to sell the stock?

Consider doing the zero-cost collar, a combination of writing a covered call and buying a put on the same stock (or ETF).

When you write a covered call, you receive income (from the premium you receive when you “write” or sell it); you can then use this income to buy the put. This combination is called a collar because it effectively boxes in, or collars, the stock price. Here’s how events may play out:

  • If the stock goes down: The put that you bought comes into play. The put will increase in value the more the stock falls.

  • If the stock goes up: You make a small profit on the stock when it’s sold at the strike price of the call option you wrote. But that’s it, because the covered call limits your upside; you can’t realize any gains above the strike price.

  • If the stock moves in a flat or sideways manner: Both the call you wrote and the put you bought would expire. No worries, though. Your stock is okay, and because both positions were acquired as a zero-cost collar, no harm is done when they expire. The collar didn’t cost you, so there’s no real loss.

Try selling puts

Say you have a stock with a loss. You review the wreckage and see that the stock price may be down (negative!), but everything else about the underlying stock and its company are positive.

Suppose you have a stock that went from $50 per share and is wallowing in pain at, say, $25. Do you sell and take the loss, even though the company is really hunky-dory? Measure twice on this — is the stock price down only because investors left the sector entirely due to factors that are temporary and not fundamental to real value in the sector?

Say that the company is fine but you could use the loss for tax purposes (capital losses in your portfolio are generally deductible). So consider selling the stock and then writing a put option on the same stock. Why? When you sell the losing stock, you pick up the loss on your taxes. Also, because the stock is down sharply, the puts on it are probably “fat” (meaning they picked up lots of value due to the stock’s price drop).

Given that, write a put option on that stock; it will give you good income and you can lock in a good price because the put will require you to buy the stock at the lower price (the strike price in the put option). The bottom line is that you took a bad event (the stock’s fall) and turned it into something more positive.

Prepare your exit strategy

Stocks are meant to be a means to an end. You get stocks either for income or gains, maybe both. If you have a great stock and you’ve been getting great (and growing) dividends, year after year, then an exit strategy is either not a consideration or not a major concern. You develop an exit strategy for that type of holding in case you really need the money for a concern outside the realm of investing, such as funding college for your grandchild or buying that retirement home with all cash, no mortgage.

When will you exit your position with stock X? And why? What type of scenarios would make you sell that particular stock? Give exit strategy some thought before the need to sell materializes. Many investors think about an exit strategy even before they make the initial purchase.