Risk management tips for active traders

Professional investors, especially billionaire hedge fund managers, spend a lot of time carefully reviewing their portfolios to ensure risk is minimized. Unfortunately, many investors fail to take the necessary steps to do the same and evaluate their holdings.

One of the most important questions investors need to ask themselves from a risk management perspective is: how much money should be allocated to a new trade.

Common logic dictates the answer is that no one individual holding should be large enough to severely impact the total value of a portfolio. For example, if an investor holds 10 different stocks in their portfolio and one of them drops to zero, the investor should not enter financial ruin given a diversified holding.

In fact, an investor could still end the given year with an overall profit if the remaining assets perform well.

Now, the main drawback of a diversified portfolio is the fact that it dilutes return. For example, a 300% return on one stock in a portfolio is certainly appreciated but may not be large enough to change a person’s life from a financial perspective.

A second layer of risk management is to carefully plot out exit points should the stock move in the wrong direction. Known as a stop loss, an investor can automate a sell order if the stock loses a certain value, for example 10%.

Suppose an investor wants to invest $200,000 and buy shares of communications giant BCE. As of August 15, 2022 the stock was trading near $65 which implies a purchase of 3,100 shares. A 10% stop loss would imply a drawdown to around $58 per share and this will result in a loss of $20,000.

Risk management strategies using options

Using the example above, an investor can lower their overall risk profile through options. If the investor is very bullish on BCE’s stock outlook, they can buy 31 call option contracts (representing 3,100 shares) at a strike price of $75.

The investor can easily calculate the total loss from this option position. If it is less than $20,000 then the investor essentially puts themselves in a position to take advantage of a strong move to the upside while accepting a lower total loss if the trade fails to move as anticipated.

This strategy takes full advantage of margin and leverage that options offer. Specifically, options offer the potential for outsized returns versus owning the stock outright and a lower total loss. The only drawback is that in the example above, if shares of BCE rose to $70 at the time of expiration, the options would expire worthless. By contrast, the investor would have pocketed a smaller than expected profit by owning the stock outright.

Another example of how options can play a role in risk management is through minimizing losses. Suppose the same investor is bullish on BCE’s stock outlook but recognizes weakness in the broader market. The investor is assuming that general market sentiment will soon sour and send shares of quality companies lower.

The investor who bought shares of BCE at $65 can simply buy a put option on BCE’s stock with a strike price of $55. Armed with this downside protection, the investor will see the value of their BCE holding decline by roughly $10 per share.

However, we would expect the value of the put option to rise in value so the impact would be less severe compared to holding the stock outright. Suppose the value of the put options rises by hypothetically $25,000, the investor’s profit and losses are as follows:

• Stock: $10 per share loss times 3,100 shares = $31,000.
• Options: Gain of $25,000.
• Total loss: -$31,000 + 25,000 = loss of $6,000.

The gains from the put option should at least partially offset losses from holding the stock. In this example, the investor hedged against downside risk and recouped $25,000.

Of course, the main component of risk management is to carefully evaluate a trade from all perspectives and then do what is best for your portfolio based on your objectives.

Trading options can be a very valuable tool for investors when used effectively. But a proper understanding of the logic and math behind a trade is essential to avoid careless errors that result in unnecessary losses.