"There should be less volatility in a broad-based index fund," says White. She recommends that the novice start with passive index inverse funds.
These inverse funds are relatively new, so there is no performance history, and if the fund is actively managed, commissions can be high. If you want low-cost, look for passive inverse funds that track the index. When you sell a fund, you will also realize some short-term gains, which are taxed at ordinary income rates.
- Correlation -- a statistical measure of how two securities move in relation to each other.
- Leverage -- Using borrowed funds, or debt, to increase equity returns.
- Derivatives -- financial instruments where the value comes from the underlying asset, which could include stocks, interest rates or currency exchange rates and real estate.
- Options -- A contract that gives a buyer the right, but not the obligation, to buy or sell a particular asset, like a stock.
OptionsThere are many options strategies for protecting individual stocks. Here is an explanation of two of the more common options: equity collars and protective puts. Both are meant to protect you from a stock dropping below a set point, called the strike price, or exercise price, and are best used for the short term, when you believe the market is volatile or dropping.
If you buy a put and sell a call on a stock you are hedging your bet with a "collar" that won't allow for much downside or upside variation in the original stock price. So while you limit your risk, you also limit your profit.
Collars are a way to protect against short-term risk, but since they also remove upside potential, you only want to use these for the short term. Since you're selling the call, you can use the proceeds to offset the price you paid to buy the put, making this a low-cost strategy. Your goal is to protect yourself against temporary volatility, not to realize huge profits.
Puts and married puts: Unlike equity collars, where you limit both risk and profits, here you are buying downside protection, while leaving theoretically unlimited upside potential for the stock.
The difference between puts and married puts is in the time you purchase them. Married puts are bought at the same time as you buy the stock, which gives you immediate protection on the stock. Regular puts can be purchased on a stock at any time.
When you buy puts, you usually buy one contract for every 100 shares of stock that you own. You determine the strike price and the date you want to exercise. A price close to the price of the stock, which is called "At the Money," gives you the most protection, and is more conservative and expensive because your downside risk is limited. If you want to protect yourself from steep losses, you can purchase a put with a strike price much lower, which is called "Out of the Money."
Let's look at an example: If you purchased stock for $100 a share, and a September put for $15, the stock would have to rise to $115 a share by the September exercise date in order for you to break even.
If, on the other hand, the stock drops below $100, you are protected. Remember, the strike price was your "insurance" when you bought the put.
Advantages: If you're feeling shaky about a stock you own, and it makes up a large part of your portfolio, you can gain some comfort in the insurance.
Disadvantages: Options, including puts and collars, can be fairly complicated, you have to make your own best guess of what the market will do in order to determine the exercise date -- never easy in these times. "Options are a fairly sophisticated process for the average investor to figure out," says Ansari.
"There are so many different elements with selecting the proper date and strike price; it takes time," White says. She suggests that investors who are new to options start with protective puts, and then move up to collars if they see the need, and are comfortable with the strategy. "With a collar, you need to understand that the stock can be called away -- you have to be prepared to lose the stock. That's not the case with protective puts alone," she says.
In an equity collar, you lose the unlimited upside of the stock potential, and your profit or loss depends on the strike price. It could be tricky to determine the correct put and call combination that gives you some profit and still protects you against loss.
Puts alone are more expensive to buy than the collar, but with a put, you don't limit the upside potential of the stock.