Reducing Risk in a Stock

Those of you who have invested in the market for some time have no doubt experienced a rally in the market. Sometimes you are even amazed at how well a specific stock in your portfolio has done. In fact, you are so amazed that you may believe that stock will continue to rise. However, you must remember that until you sell, all you have is a paper profit. While your stock may keep rising, often those very same stocks come back down.

One of the more difficult decisions to make in the market is when to sell. Regardless of when you sell, you almost always secondguess yourself. The thought process you used when you purchased the stock does not appear quite so useful, because you want to make as much as you can. You may even put the question off and try not to answer it, but in most cases you cannot delay for very long. So what we want to know is can this particular stock continue to keep going up and if so, how high? Not only that, but also how can I participate, yet keep my exposure to a minimum?

There is a strategy that may allow you to participate in further gains in the stock while also cutting your risk in it. This strategy is selling your stock and then purchasing a call option on it. Remember that a call allows you to purchase a stock at a given price within a specific period of time. Selling the stock locks in a profit for you. Then you take a portion of the profits and use them to buy the calls. You don�t want to go hog-wild here. If you sold 500 shares of the stock, then simply buy five calls. Do not take all of the proceeds and use all of the profits to buy as many calls as you can. Buy only as many calls as you had round lots of the stock. This is how you lock in a profit and save for that rainy day.

Should the stock continue to rally, then the calls will rise and you will still participate in that rally. However, should the stock decline, you can lose only the premium you paid for the calls. Since you only took some of the profits and not all of them, a drop in the stock will reduce your ultimate profit. However, you will still have a profit overall, and if the stock falls sharply, you will be much better off having owned the calls instead of the stock itself. Plus, you will have reduced your risk in the position.