The Best Way to Cut Your Risk Before Tomorrow’s Interest Rate Decision

On Thursday, the Federal Open Market Committee – the Fed’s monetary policy committee – will meet to discuss whether or not to raise interest rates for the first time in roughly nine years.

The recent selloff has cast some doubt on what they might do – raise rates and hope for the best, or keep rates near historic lows through the end of the year to let the market find its legs.

But no matter what the Fed decides, you’ve got to stay in the markets. I’ve said before that one of the costliest mistakes you can make as an investor is to sit on the sidelines. If you want to make money, you have to be in the markets. So if you want to win – no matter what the central banks do, and no matter what the markets do – you have to keep playing the game.

Sometimes, that’s easier said than done, I’ll admit. But the easiest way to stay in the markets in tough times is to make sure you’ve got a sound risk management strategy.

In fact, when it comes to making consistent money in the markets, controlling your risk in your trades – and managing your losses – is just as important as anything else you do as a trader.

Today, I’m going to show you why options are the best risk management strategy in the markets – and four concrete ways you can use them to protect your investments and manage your risk.

I have shown you how to make good, consistent money with options, but did you know they were created just as much as a way to control risk as they were to engineer profits?

The four ways I am going to show you options as a risk management strategy are as follows:

  1. Owning Options versus owning a stock
  2. Using options to hedge a stock you already own
  3. Using options to hedge other options
  4. Using options to hedge your entire portfolio

Owning Options Vs. Owning a Stock

The biggest risk faced by investors is price risk – that’s the risk that your investments will decline in value. Price risk can be mitigated by diversifying your portfolio, or by employing a variety of hedging techniques.

But the only way to truly lower your price risk is to put less of your capital at risk in the first place.

And the best way to do that is to buy options instead of buying stock.

Options are great risk management strategy in that you can control 100 shares of a stock priced at $100 for far less with the purchase of a two month out expiration $100 call option.

The stock would cost you $100 x 100 shares, or $10,000.

The option, priced at $7 would only cost you $700, (1 contract = rights to 100 shares multiplied by the $7.00 cost per contract = $700).

It is unlikely the stock ever gets delisted or stops trading, but technically your risk is that the stock goes down to $0 in price, which would result in you losing the full $10,000.

Meanwhile, the most you could lose on the option is your initial $700 investment, which is considerably less.

Using Options to Hedge a Stock You Already Own

Everyone that owns a stock knows that when the stock goes lower in price from what you bought it for the stock is losing value resulting in your account value decreasing.  You don’t actually realize the loss until and if you sell the stock at any lower price than you bought it.

Another great way to use options to lower your risk is to buy put options to offset potential losses on a stock that you already own.

Let’s say you own a stock for $70 per share. Let’s say you learned that having a 10% loss amount as a way to minimize risk is a good way to go.  This means you would have in place a stop loss order at $63 per share, (10% of $70 is $7.00 subtracted from the $70 = $63).

This is a time-tested strategy that works to minimize your risk… until a report about the company and some accounting irregularities is released overnight, causing the stock to open at $35 the following day.

Your stop order hits at that $35 mark rather than at your targeted $63 level, causing a considerable loss to your account – a 50% loss, in fact. Not a great way to start your day.

You could have bought a put option as a way to protect against these kinds of catastrophic losses.

Here, let me show you.

As we’ve talked about, a put option gives the buyer the right to sell a stock at a specific price on or before a specific date.

So if you bought the $70 put to hedge your $70 stock, you would have the right to sell 100 shares of that stock back to the market for $70 no matter where the stock is currently trading on or before the expiration date.

Sure, the option could expire and the cost of the put – insurance, if you will – would be lost, (unless you sold the put for a gain). But the loss on the put contract would be much easier to take than the losses on an unhedged stock position.

Many traders see the price of put options as simply the cost of doing business, especially on expensive or volatile stock positions.

Using Options to Hedge Other Options

If you’ve been following along with Power Profit Trades, you’re already familiar with this technique… this is exactly what we’re doing when we execute a “loophole trade.”

Options can be bought as a proxy way of owning the stock. Instead of buying shares of Caterpillar Inc. (NYSE:CAT) in anticipation of the stock going higher, you could buy a call option. Here is an example where CAT is trading at $72.68.

Let’s say you bought a slightly In the Money, (ITM) call option (in this case, the October 2015 $70 calls). Its current mid-price shows it could be bought for $3.88, or $388 for one contract.


But let’s say your risk management plan dictates that you aren’t to spend more than $300 per trade. You would not be able to purchase that contract because it would cause you to break your money management rules – and you are not going to do that, are you?

That’s where the loophole trade comes in. You can simultaneously sell a call option against the call option you want to buy.

When you buy one call option for a specific expiration date and sell a call option for the same expiration, but with a higher strike price, you are creating what is called a Call Debit Spread. It is also known as a Bull Call Spread.

It is an option strategy used to reduce the risk from just buying a straight long call option.

To buy the October 2015 Week2 $70 call would cost $3.88 for the one contract, or $388. But when you also sell the October 2015 Week2 $75 call, you bring in $1.23 (mid-price), or $123.


The cost to buy the call option that you’ve targeted is now offset by the premium of the call option you sold, or $1.23.

So your out-of-pocket cost would go from $388 to $265 ($388 – $123 = $265).

This is a savings of almost 32% ($1.23/$3.88 = 31.7).

Since cost is risk, you have reduced your risk by close to a third of the cost of just buying the call.

Using Options to Hedge Your Portfolio

Those of you who have been investing for a number of years probably own at least a handful of stocks. If you’re saving for retirement, your financial advisor has no doubt put you in an array of indexes and mutual funds to build your wealth.

That’s a fine “buy and hold” strategy, but it means that when the markets eventually move lower – and they will – your entire portfolio is at risk of taking a tremendous hit.

Now, how well you’re diversified may help with risk in that some sectors may not drop as hard as others. Some stocks may hold up well compared to others. Still others may rise if they aren’t exposed to whatever contagion is plaguing the markets. But it’s hard – if not impossible – to predict which stocks are going to withstand the next market crash.

But there’s one last way you can use options to manage your risk, and that’s to buy puts on a broader index that includes the stocks in your portfolio.

If you’re invested in the markets, your best bet is SPDR S&P 500 ETF (NYSEArca:SPY), an exchange-traded fund that tracks the S&P 500.

If you see a market decline coming our way – despite what the Fed says tomorrow – you could consider buying SPY puts, say At the Money (ATM) or slightly Out of the Money (OTM), commensurate to the dollar amount of shares you own.

For example, right now, SPY is trading around $198.50. To properly hedge a $20,000 stock portfolio, you’d need to buy one put options. That would give you control of 100 shares, valued at $19,850.

When the market drops, your puts should increase to the point that you’re roughly breakeven on your portfolio value, or should at least reduce the value of your loss (remember, it is not an actual loss until you sell your stock).

Of course, with the purchase of puts as insurance, you run the risk of not having to cash in your insurance or the puts could decrease in value with a run up in the markets. This is true with all insurance though, isn’t it? You buy insurance just in case… the same is true when you’re hedging with options.

Here’s Your Trading Lesson Summary:

Options are the best way to manage your risk. Here are four ways to use options to cut your risk:

  1. Owning Options versus owning a stock
  2. Using options to hedge a stock you already own
  3. Using options to hedge other options
  4. Using options to hedge your entire portfolio

Be back with you soon.

Good trading,

Tom Gentile

4 Responses to “The Best Way to Cut Your Risk Before Tomorrow’s Interest Rate Decision”

  1. So, Kent (Micro Energy Trader) is recommending stock purchases usually, but, like you, I would prefer options instead. So he is currently pushing HNR, how would I apply your method effectively to his recommendation since he does not recommend any options, but only straight share purchases? Thanks,

  2. So how would I apply this to something like Kent’s recommended stocks (Micro Energy Trader) – currently HNR? Since I have joined that segment, he has never recommended anything but stocks only. I fully agree with your guidance that options are better, and following “most” of your recommendations, I have paid for the MoneyMapPress subscription many times over, thank you! I am still learning about options, but don’t want to lose the farm betting on my expertise, especially after following your simple recommendation in MoneyMapAlert.

  3. Etienne, thank you so much for the comments… but YOU are the one that should be thanking yourself, you pulled the trigger! But compliments go a long way, so that being said, lets have a look at HNR..

    Never heard of this stock and now I know why… its 1.50 a share. I typically dont trade options on stocks below $10, so thats why it didnt immediately come up on my radar. While theres no problem trading options on cheap stocks to get the leverage, if the option isn’t widely bought or sold (illiquid) than the spreads wont be worth the reward. The stock might be bid and offered at a penny apart, but looking at the January 2017 at the money calls, they are bid at .10 and offered at .75. Terrible spread. Thats nearly half the price of the stock in the spread. The second thing I see is that total open interest in all the call strikes listed yesterday was just 6 contracts, and total volume yesterday was 0. So I think if you really love HNL, trade the stock, not the options. Hope this helps!


Leave a Comment

View this page online: