Excellent risk management & strategic thoughts here from Barrons:
One way to combat this risk is to initiate stock-replacement strategies that replace shares with a call option. This strategy lets investors profit from additional upside in the shares, while cashing in profits and limiting the risk to the amount of money spent to buy the option.
The strategy is capital efficient, enabling investors to free capital and invest it elsewhere — like bonds to reduce risk, or maybe even another stock or an exchange-traded fund.
Consider shares of IBM (ticker: IBM) as an example. With the stock at $116.86, investors can replace shares with a January $120 call; the cost of the trade is $6.60, or 5.65% of spot (cost of the stock), freeing 94.4% of the total notional invested in the stock.
“This trade locks in a bulk of the 38.9% return year-to-date for IBM, while the max drawdown is limited to the premium paid,” says Palsson.
Realize profits. Maintain upside exposure at the same time. Limit risk. Welcome to the third dimension of investing.
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Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
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