How Can You Reduce Risk?

With the markets in turmoil world wide many people are looking for ways to reduce their risk. There is of course no perfect way to invest in equities without risk but you can lower exposure to it.

The number one thing you could do would be to adjust your portfolio so equities make up less. You also do not want to be on margin or leveraging, but there are leveraging tools which can reduce risk and those are options.

Buying covered calls can be a great way to generate money while you wait for your investment to turn around. This can work even better if you have a stock that pays a decent dividend combined with your covered call. The downside is that you will not get full value if your stock was to rise dramatically.

Example of a Covered Call
You buy XYZ company today for $42, at the same time Sell July 2009 48 calls@2.50. Your calls right away give you almost 6% back on your investment right away! Now lets look at what happens after that.

Scenario #1) The stock closes above 48 on the 3rd Friday in July and your option is executed. You receive 6% from calls+capital gain on stock of about 14%% =total return 20% for a little over 5 months. Not to shabby!! This does not take into account your dividends either so return would be even higher on a stock with a good dividend payout.

Scenario #2) Stock close below 48, you receive 6% from call, Now the stock maybe down or could still be above your purchase price of $42 but not over the strike price of 48. Worst case is you lowered your break even from $42 to about $39.

Obviously if your stock is a falling knife this will not save you, but if you believe you have a solid company, especially one paying a good dividend, writing calls can help a lot over the year. Covered calls are not a magic bullet but they can help reduce or lower your losses if you plan on holding. Options are very complex and should not be attempted by those who are inexperienced but they are definitely worth consulting your financial planner about.