Stocks & Commodities V. 26:8 (42-47): Stock Insurance Policy by Sylvain Vervoort

Stock Insurance Policy by Sylvain Vervoort

Here’s how you can ensure your positions in stocks by combining them with options.

There are certain facts about buying stocks, among which are: Fact 1: When the price of a stock is making a longterm up move, the only mistake you can make is to buy that stock at the wrong time by just looking at the short term. Fact 2: To hold a position during a longer-term price up move of 30% or more, shorter-term price reactions of 10% up to 13% (for the more volatile stocks) must be accepted.

From the chart of Salesforce.com (CRM) in Figure 1, it is likely you will be tempted to buy the stock after the February 2006 correction and the price breaking above the red descending trendline.

The blue dashed line is a 12% trailing stop. Using such a liberal stop kept us in the trade until a top at the beginning of February, when a third sharper uptrend line was broken. A number of days later, the 12% trailing stop was broken by the closing price for the first time since the start of the uptrend at the end of August.

Fact 3: You should accept the fact that 50% of your trades are going to lose money. Figure 2 clearly shows that it was not the right time to buy CRM.

Fact 4: If 50% of your trades are making a loss of 10%, then the profitable trades must make around 25% to end up with a high-enough final profit.

Fact 5: When applying good money management, the money lost in one single trade should not exceed 1% to 2% of the total trading capital.

Since you have to risk up to 13% of the investment when opening a position, wouldn’t it be nice to have some form of insurance that would always limit the loss to that level, no matter what happens within a certain time period?

OPTIONS INSURANCE POLICY

Using put options as insurance right from the start when buying stocks lets you sleep at night because you know beforehand exactly what risk you are taking. This strategy is referred to as a synthetic long call.