Insurance is a very valuable thing to have on expensive items. In the case that a car breaks down or is involved in an accident, car insurance is set in place to cover the cost of the damages and either repair the car or replace it with a new one. In the case of any damages done to a house or anything gets unlawfully taken from the home, house insurance is set in place to cover the damages or to compensate the homeowner for the stolen goods from the home. So in the case of investing money in the stock market, is there an insurance plan that is set in place to cover losses in the stock market?
Although there is no insurance plan officially called stock insurance, there are three main methods that can be used to limit stock losses.
- Insuring stocks by using future contracts.
- Insuring stocks by using call or put options.
- Insuring stocks by using stop-loss and stop-limits.
Use Futures Contracts
Futures are defined as the contract that requires the owner of the stock to buy the underlying asset at a specific price at a specific date. Neither the price nor the date can be changed at any time. On the other hand, the person who is responsible for selling the futures is required to give the owner the underlying asset in the same manner that the owner is obligated to buy the asset. In case there is an uncertainty of the exact role of futures, here is an example that would clear things up:
Example of Using Futures
An investor is the owner of a portfolio that includes a large stock in Microsoft. The investor is predicting that the stock will drop in the next six months to at least 10% in the price that it is currently. The investor does not plan to sell the stock right away, but wants to sell before the decline in order to avoid losing anything because of the decreased stock. It would be beneficial for the investor to limit stock losses by selling the futures contract.
Another way to limit stock losses is the use options. Options are the portion of the contract that allows the owner the right to either purchase or place for sale the underlying asset at a specific price either on or before a specific date. Keep in mind that buying and selling is only a right and not an obligation. There are two different types of options—call options allow for the right to buy the asset and put options allow for the right to sell the asset. Here is an example of how using options can help to limit stock losses.
Example of Using Options
In addition to the stock investment in Microsoft, the investor mentioned above also has stock in General Motors. In fact, the investor has 50,000 shares in the company. The investor has also predicted a drop in the price of the stock in the next couple of months. The investor wants to make sure that there is no more than a 10% loss if the stock were to drop. To limit stock losses, the investor can buy 500 put options which will include a strike price at 10% under the present price of the stock with an adjoining expiration at three months. Even if the price of the stock were to decrease by more than 10%, the investor will still be able to sell the put options without losing any money.
Use Stop-Loss and Stop-Limit Orders
The last way to limit stock losses is to use stop-loss and stop-limit orders. A stop-loss order is one type of order that is often placed with the investor’s stock broker in which there is an immediate order to sell the shares when the price of the stock itself is predicted to fall to a specific price. Once that specific price, which is called the stop price, is finally reached, the order is then carried out as a market or as a limit order. Here is an example:
The same investor mentioned above has a portfolio with 1,000 shares in Wal-Mart. Unfortunately, the company has released a report on its latest failed attempt to attract more customers and the investor’s stock broker is convinced that the bad attention may cause the stock to decrease in price. The investor decides to create a stop loss order setting the stop price and the stop limit at 10% under the current price of the stock. This attempt to limit stock losses guarantees that if the stock were to drop more than 10% below its current price, the investor will still be able to sell the stock at the stop price. If the stock were to increase in price, the stop price and limit will readjust to suite the higher price.
In conclusion, the best way to protect hard earned investments is to back them up with a reliable insurance method. The best way to insure stocks is to use stop-loss and stop-limit orders, to use options, and to use futures.