The Best Insurance Policy for Speculative Trades

Sometimes, investors try to look for stocks to score a “home run”—speculate on them to double, triple, or even increase 10-fold in prices. Unfortunately, in hindsight, they forget the amount of risk they are taking.

At the very core, speculation is about taking higher risk in the hope that the gains will be exponential.

As I have been saying in these pages, the goal of investing is to grow savings over time by minimizing risk—to focus on long-term growth over short-term gains.

When a person speculates, he or she leaves their portfolio vulnerable to a significant drawdown. Mark Twain said it best: “There are two times in a man’s life when he should not speculate: when he can’t afford it and when he can.” (Source: ThinkExist.com, last accessed March 26, 2013.)

Speculation isn’t easy, and not every investor should try it; but if an investor does go ahead and tries to speculate, then they must make sure their capital—as much capital as possible— is protected in case things turn against them.

Consider this scenario: say you bought 1,000 shares of pharmaceutical company XYZ Inc. for $10.00 each, hoping that the stock will go to $50.00 on the approval of the company’s drug by the government. Sadly, a few weeks later, you find that the drug was not approved, and the stock now trades at $5.00, 50% lower. Your loss on this trade is $5,000 (calculated using the starting value of $10,000 minus the current value of the stock).

To protect their losses, investors can use an option strategy called the “protective put.” In essence, a protective put is like buying an insurance policy for your speculative position. With this option strategy, an investor buys a put option for a strike price similar to the current price of the stock.

Going back to the example above, instead of just buying the XYZ Inc. stocks in hopes it will increase in value, investors should purchase a put option at a strike price of $10.00 expiring in the future.

How’s the investor’s capital protected? If the price plummets, just like in our example, the value of the put option will go up in the same manner, gaining back the losses created by the fluctuation in the stock.

If an investor employs the protective put strategy, then their loss will only be the cost of buying the put option, rather than $5,000—you could call it the “insurance fee.”

While investors might be tempted to speculate and attempt to make multiples of their returns, they must keep in mind that it takes time and a lot of resources to become a successful speculator.

An investor can achieve the same types of returns over the long term with peace of mind. Look at the performance of investors like Warren Buffett. He believes in holding a company forever—and to be quiet honest, he has done well and is a pioneer of investing for the long term compared to the short term.

The markets will fluctuate in the short term, but over a long period of time, they have a trend, be it upward, downward, or sideways. If an investor is saving money for their retirement or if they are close to their retirement years, speculation is not for them. With all this said, if they still try to speculate, then they should make sure to preserve capital and use strategies like the protective put.

This article Understanding the The Best Insurance Policy for Speculative Trades was originally published at Daily Gains letter and has been republished with permission.

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