Chapter 1: Advanced Risk Management
Quick recap of the basics
Beta Management: By selecting stocks with beta values that align with your risk tolerance, you can balance your portfolio's overall volatility. Aiming for a target beta helps manage risk by ensuring your investments are neither too volatile nor too stable relative to the market.
Liquidity: Maintaining a portion of your portfolio in liquid cash allows you to take advantage of market opportunities and handle unexpected expenses. This flexibility can lower overall risk and improve your ability to respond to market changes.
Basic Hedging: Investing in assets that move inversely to others in your portfolio helps balance risk. For example, buying gold to hedge against stock market declines can protect your portfolio from significant losses.
Using other financial tools as a hedge
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An option is a financial tool that lets you buy or sell something at a fixed price in the future. There are two main types of options: calls and puts.
Call Option: This gives you the right to buy something at a set price before a certain date. If the price of that thing goes up, you can buy it at the lower price and make a profit.
Put Option: This gives you the right to sell something at a set price before a certain date. If the price of that thing goes down, you can sell it at the higher price and make a profit.
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Options can be used as a hedging technique to protect against potential losses in an investment. By purchasing a put option, you acquire the right to sell a stock at a predetermined price, which can offset losses if the stock's price drops. Similarly, buying a call option gives you the right to buy a stock at a fixed price, which can be beneficial if you're short on the stock and its price rises, limiting potential losses from adverse price movements.
An example
Imagine you own 100 shares of a company currently trading at $50 per share. You're worried that the price might drop, so you decide to buy a put option to protect your investment.
You buy a put option with a strike price of $45, which gives you the right to sell your shares at $45 each, no matter how low the price might go, before the option expires in three months. This put option costs you $2 per share, so you pay $200 in total (100 shares x $2).
If the share price falls to $40, your shares would have lost $10 in value each. However, because you have the put option, you can still sell your shares at $45 each, limiting your loss to $5 per share (plus the $2 per share cost of the option), instead of $10 per share without the put option.