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First time stock investors may ask if there is a way to buy insurance on stocks to prevent losses.
At the moment, purchasing insurance for stocks isn’t as easy as buying a policy for your portfolio. However, there are ways to insure, or hedge, against stock market losses.
Diversifying your portfolio and utilizing variety of options can help prevent an investor’s stocks from suffering substantial losses.
To diversify a portfolio is to reduce your non-systemic risk by investing in a variety of assets. Through diversification, the net loss realized from a decrease in stock prices will balance returns from other assets.
When approaching a diversifying strategy, it is important to spread the wealth between investments with constant and volatile returns. With respect to the stock market, safe stocks are ones which do not witness volatile movements in prices and pay dividends. Investing in a whole index such as the S&P 500 or Dow Jones Industrial Average, which encompass many stocks, is a more effective strategy to insure individual stock investments.
Bonds, commodities, currencies, and funds are also valuable assets to diversify a portfolio. In particular, U.S. Treasury Bonds backed by the U.S. government are deemed by the most conservative investors to be the safest asset. A portfolio that holds a percentage of 10- to 30- year U.S. Treasury Bonds can ease risk-related stock market losses. (See also: Risk and Diversification: Different Types of Risk.)
Options can be a valuable tool to hedge risk and insure stock losses. An option is a contract between two parties in which the buyer has the right to buy or sell a stock at an agreed upon price within a pre-determined date.
A call option gives the investor the right to purchase a stock at a strike price with the expectation that the stock will increase in value beyond the strike price. Conversely, a put option gives the investor the right to sell a stock at a strike price with the expectation that the price of the underlying stock will decrease. Purchasing stock options for individual stocks is a valuable way to protect risk related losses associated with volatile stocks.(See also: Options Basics Tutorial.)
Other Types of Options
While stock options can be a safe way to mitigate risks of investing, there are a variety of different options that give investors leverage and market exposure. Like stock options, index options are a financial derivative which draws its value from an underlying index. The contract owner has the right to buy or sell a basket of assets such as the S&P 500 or Dow Jones Industrial Average. In particular, index put options provide insurance to investors in a bear market.
During a bear market, assets in an investor’s portfolio will decrease while an index put option will generate positive returns. Like index options, ETF options insure a sector of stock investments. ETF options can replicate whole indexes or specific sectors such as energy, healthcare and technology. While index options are cash settled, ETF options can be settled in the underlying asset.
Different from both index and ETF options, VIX options allow traders to speculate on market volatility without factoring in the price of the underlying instrument. As a cash settled asset, VIX options are a great way to diversify and hedge portfolios. (See also: The 4 Advantages of Options.)
The Bottom Line
The stock market is very unpredictable with profits and losses realized every day. Insuring your investments can be a valuable means to prevent substantial losses.
Diversifying your stock portfolio is essential for any investor in the stock market. By diversifying a portfolio, an investor will acquire assets uncorrelated with the ones they currently own to balance losses. Diversification can be done in several ways, not only by purchasing a variety of stocks. Bonds, commodities, funds and particularly options are a valuable method to insuring your stock investments.