Hi, Felix here with my trusted financial advisor Tallulah! Today, I want to share with you a strategy that will help you avoid losing money on growth stocks. No, it’s not a scam or an over-promise; it’s a straightforward method that even hedge funds use. As a former hedge fund strategist, I can assure you this strategy works. Let’s dive into it!
Understanding the Risk
Imagine you own 100 shares of Microsoft, trading at $313 per share, totaling $31,300. What happens if the market crashes and Microsoft’s share price drops significantly? For instance, if the price drops to $220, you’d be looking at a loss of $9,300, about 30% of your capital.
Hedge Fund Strategy
Hedge funds employ strategies to mitigate such risks. Let’s call our hedge fund manager Brad. Brad holds the same 100 shares of Microsoft but loses significantly less in a downturn compared to you. At $220, he might only be down 7%, while you’re down 30%. So, what’s Brad’s secret?
The 2-Step Process
The core of this strategy involves options trading – specifically, using put options and selling call options.
1. Buying a Put Option: A put option acts like an insurance policy for your shares. If the share price drops below a certain level, the put option kicks in and compensates for your losses. For example, buying a put option for Microsoft at $292 might cost you $86.50, but it protects you from significant losses. If the stock drops to $238, your put option delivers a $5,323 return, providing you with cash to buy more shares at the lower price.
2. Selling a Call Option: To offset the cost of the put option, you sell a call option. This means you agree to sell your shares at a higher price if the stock rises. For instance, selling a call option at $330 can bring in $86, balancing out the cost of the put option. While there’s a small risk of having to sell your shares if the stock rises sharply, the likelihood is relatively low.
Practical Example
Let’s walk through an example with SoFi, a growth stock. Assume you own 100 shares of SoFi at $7.45 each. You buy a put option at $6.50 for $5, providing downside protection. Then, you sell a call option at $8.50 for $4, nearly covering the cost of the put option. This setup limits your losses and gives you cash to buy more shares if the price drops.
Summary
By using this 2-step process weekly, you create a hedge against significant losses. Your maximum loss is limited, and you gain the ability to buy shares at lower prices during market downturns. Practice this strategy using paper trading accounts on platforms like Think or Swim or WeBull before investing real money. With time and practice, you’ll master this approach and confidently navigate the stock market, ensuring you never face devastating losses again.
Final Thoughts
Remember, the key is to set up these options every Monday with an expiration on Friday. This way, you’re always protected, especially during volatile market periods. As you gain experience, you’ll refine your strategy and better manage your investments.