The broader markets have hit numerous all-time highs in 2021, fueled by robust corporate earnings beating analyst expectations by healthy margins, easing yields, an accommodative fed, and economic optimism with a vaccine rollout well underway. While this has been welcomed by investors who partook in the rally, it is important to consider risk management techniques during periods of euphoria. Emotions are investors’ greatest enemy. In our experience, a requisite of significant and sustained portfolio growth is the discipline to implement and adhere to best practices for protecting capital based on risk tolerance. There is no one size fits all approach when it comes to risk management. It’s important for everyone to consider their own risk management needs, and if necessary, consult a financial advisor. In the rest of this article, we will discuss several strategies that we deploy to effectively manage our risk and exposure to the equity markets. These include:
- Position size / game plan
- Writing covered calls
- Buying puts
Position size/game plan
An important component most successful investors/traders leverage is creating a game plan and understanding the risks and max pain they are willing to withstand. Some helpful guidelines we have found throughout the many market conditions we have experienced are;
- Only take speculative positions which you are willing and able to lose. Market conditions can change and unforeseen press releases can leave you down big with no warning. For trades and investments which aren’t our core conviction/long-term investments, we tend to take small positions which we are able to cut in a worst-case scenario.
- Important questions to consider:
- What is your max pain (what’s the most you’re willing to be down before you cut the position as a loss?
- Sometimes it’s beneficial to take a loss and re-enter at a better price
- Be aware of key levels of support and resistance
- What price target do you want to sell at? Oftentimes traders will pick a winner but get too emotionally involved and miss the opportunity to realize a profit in hopes of making more money
Writing covered calls
Writing calls can allow you to maintain your position while also making money during the inevitable downswings. In doing this we make sure to write out of the money calls on days when the stock is up and the options premiums are thus higher. When the stock pulls back the premiums come down and the investor can buy them back at a profit. The primary risk here is getting exercised and having to sell your shares at the agreed-upon price (the strike price). Here are some more details on how it works;
- We find the most attractive out of the money calls which we fundamentally believe have a slim chance of being exercised (meaning the share price is unlikely to hit the strike price by the specified date).
- We look for highly-priced calls that are significantly out of the money
- If the calls fundamentally are attractive to write; we enter the quantity we are willing to risk and select “sell to close.”
- 1 call = the right to buy 100 shares at the strike price
- Once filled we are now positioned to collect premium as the call comes closer to expiry and or the share price pulls back
- We can either cover and “buy to close” to close out your position and collect the premium, or we can let them ride to expiry if we believe they will expire worthless.
- We often use the premium we collect from this activity to add to our position when the stock is having a red day
When equities begin to show signs of being overvalued, we like to hedge by buying puts on companies that fundamentally appear to be a clear target for a substantial pullback. An example of this in recent quarters is companies that dropped everything to provide Covid-19 test kits, therapeutics, and other solutions which never made it to market. Oftentimes these companies will pump on questionable data with less than 5 patients, see a 300%+ increase, and ultimately be a far away from the market or even a primate model. When markets begin to pull back, these fundamentally questionable companies which have seen immense appreciation in value are often quick to give up the gains. Key components we look for input candidates are;
- Few to no approved products
- Low cash position (high likelihood of dilution in the near term)
- Questionable data
- Low amount of patients, faulty trial design, incomplete readout, early-stage data which doesn’t warrant a huge gap up
- A company rarely holds conference calls
- Numerous press releases which fundamentally don’t change the companies trajectory
Once we find an attractive candidate to hedge against the market downside, we locate the cheapest priced puts which have a decent chance of hitting.