Risk is synonymous with investment. All investments carry a degree of uncertainty. Even conservative savings investments, such as time deposits, risk losing value to inflation. Speculative stocks are among the riskiest investments. On the other hand, they offer great profit opportunities.
People invest in these and other risky assets hoping that the risks are manageable. They attempt to profit once they find ways to reduce their exposure. Professional Investors use effective risk management to limit losses or protect their capital.
What risk management strategy do they use? How do they apply them? Below, we examine some expert risk management techniques when investing in speculative stocks.
Portfolio diversification
When new investors hear about the diversification of portfolios, they may think about holding various stocks in one portfolio. This is correct, but not the whole story. The combination of stocks in the portfolio plays a huge role in minimizing risk and increasing returns.
Professional investors are often strategic when building their portfolios. They use the Modern Portfolio Theory (MPT) to create a perfect portfolio with high potential returns and manageable risks. According to MPT, investing in more than one stock automatically lowers the portfolio’s total risk.
The key is ensuring the risks on the different stocks are not related. For example, a portfolio contains two stocks. One will yield returns if it snows in December, and the other will yield if it doesn’t snow. So whether it snows or not, the portfolio will yield returns for the investor. For many professionals, the only risk in their diversified portfolio is earning less profit than expected.
Hedging using options
An option is a contract agreement allowing the investor to buy or sell a speculative stock at a set price within a specific time. Professional investors use it when handling individual stock. For example, an investor buys an emerging market stock hoping it will rise in value. But the price falls, and the investor suffers a loss. The loss could have been minimized if the investor had carried out a buy-put option on that stock.
Put options increase in value when the stock’s price decreases. The profit on the option would have covered the loss on the stock investment. As mentioned, this strategy works with individual stocks and will be ineffective if you hold several stocks.
Hedging larger group of stocks
Buying options for each stock will not work if you have a more significant portfolio. For such cases, there are index options. Index options are an agreement allowing the holder to buy or sell the value of the index at the set price. Indexes usually contain stocks from major sectors of the economy. Professionals usually use bear put options to hedge larger stock portfolios.
Other ways to hedge a speculative stock
- Average down
An average down involves going long on stocks whose prices are dropping. The goal is to hedge against previously bought stocks, which have declined significantly. The investor does this with the expectation that the stock price will rise to its previous point. If this happens, the profit from the second investment balances out the loss in the first one.
- Arbitrage strategy
Arbitrage involves buying a stock and reselling it immediately for a profit. The investor buys it in one stock market and quickly sells it in another market at a higher price. Arbitrage is a common form of hedging, especially in speculative stocks. Apart from hedging, investors use it to profit from stock price differences in two geographical locations.
- Volatility Index Indicator
Another name for the Volatility Index Indicator is the Fear gauge. Traders and investors use it to determine the market’s volatility level. It climbs during periods of high volatility and decreases as it drops. A VIX above 30 indicates high volatility, while less than 20 means low. Some ETFs track market volatility. Investors often use at-the-money calls to hedge their stocks.
Professionals use these tools to minimize their risks. But these strategies can not lessen all the market risks. Inexperienced investors should acquaint themself with all the market uncertainties so they know what to expect.
Here are the different types of market risks to be aware of:
- Volatility
Stock prices rise and fall. Sometimes, predicting the price movement is impossible. A high-performing stock can suddenly dip without warning, leading to losses. Investors deal with volatility risk by diversifying, as we have explained above. Through diversifying, you can offset the loss from one investment with the profit from another.
- Business risk
Investing in stock means expecting the company to continue to perform well. The opposite may turn out to be the case. That is why it is essential that you thoroughly research and review a company’s financial situation before buying its stock. You can minimize business risk by checking the company’s debt, revenue, ratings, etc.
- Inflation risk
Inflation affects interest rates. It also drains the value of your investment capital. Its effect on interest rates can lower your profits from any investment that accrues interest. For this reason, experts often include assets not affected by inflation in their portfolios. These include gold, real-estates, and specific securities.
- Political risks
A country’s political state significantly affects its economy. The companies in their different sectors make up this economy. If the political state of a country changes, it can cause some companies’ downfall. And if you have purchased stocks from those companies, it means a loss. That is why paying attention to a country’s politics is essential when considering a stock investment.
Conclusion
Investing in speculative stocks is risky, like all other market assets. The higher the risk, the greater the potential returns. Using different strategies to limit exposure allows you to benefit significantly from the market’s opportunities. There are many strategies, but the easiest approach is doing what the experts do.
