Managing your risk of loss is imperative for any investor who wants a winning strategy. Many investors use trailing stop-loss techniques as a risk management tool. Fewer investors employ the protective put options to insure against a sudden loss in the price of your stock. How does an investor decide which risk management strategy to employ?

Characteristics of Trailing Stop and Protective Put
Before discussing the best strategy to use, it is helpful to understand the characteristics of each approach.

A trailing stop adjusts the stop price at a fixed percent or number of points below the market price of a stock. The purpose of the stop is to protect against a move by the stock price in the opposite direction than what you expect. When the price of your stock rises, the trailing stop rises with it, helping to protect you against a larger loss and eventually capturing a portion of your profit. With a trailing stop, you continue to hold the stock so you still receive the dividends from the stock, if they are paid. Should the stock plunge past your stop, your shares are sold at the next available price, not necessarily the stop price, assuming you have not placed the stop order with a limit price. (For more on trailing stops, take a look at Trailing-Stop Techniques.)

Protective puts offer a different way to insure against a loss in a stock price. Like buying insurance, the purchase of protective puts increases the total cost of the price of the stock by the premium you pay to buy the put. However, protective puts may give the investor more control over when to close the position. You may sell the put at any time before it expires. Should the stock fall, you may collect a gain from the sale of the put, or the gain from the put will offset the loss from the stock price falling. You could also allow the exercise of the put at expiration by selling your shares at the put's strike price. The protective put covers losses below the strike price of the put, so you always know the lowest exit price.


Pros and Cons of Trailing Stops
With a stop, you are protected against a loss greater than where you place the stop price. In addition, there is no cost to enter your stop order. You only pay a commission and fees if the stop is hit and the stock is sold. The stop price climbs with the rising price of the shares. You do not have to enter another order and a stop loss does not have an expiration date.

On the down side, a trailing stop placed too close to the current price may cause you to close the position prematurely. More seriously, the price of the stock could fall precipitously overnight, opening well below your stop price. In this case, the price you will receive on a sale is well below your stop price. Finally, identifying the right place to set your stop can be difficult.


Pros and Cons of Protective Put Options
Protective put options have their own pros and cons. With a protective put, if the share price falls to zero, you will gain on the difference between the put strike price and the share price. This gain will offset the loss you incurred for holding the underlying stock. Protective puts allow you to hold onto your stock while insuring against losses. If the stock price drops, you can hold the put until you decide to either sell the put for a profit or exercise the sale of the shares. If you believe in the company and the stock price drops below the strike price of the put, you can sell the put and use the profits to buy more shares of the stock at a lower price.

The downside is that you must pay a premium to buy the put, adding to the cost of owning the stock and raising your breakeven level. The expiration date of the put option forces you to make a decision to either sell the put or exercise the option before it expires.


Selecting the Right Risk Reduction Tool
Now to address the question: What is the right risk management tool for your situation?

Situation Trailing Stop Loss Protective Put
Just bought stock and market is trending up. The trailing stop will protect you from a move down below the stop price. If the stock rises, the trailing stop will follow based on the percentage or point you entered for the trailing stop order. The protective put will insure you against a move down below the strike price should the price fall rather than rise. If the stock price continues to climb, the value of the put will fall. If you do not sell the put, you will lose the entire premium you paid to buy the put.
Stock has risen in value and you still like its prospects. The trailing stop will protect you from a move down below the stop price. If the stock continues to rise, the trailing stop will follow based on the percentage or point you entered for the trailing stop order. The protective put will insure you against a move down below the strike price should the price fall rather than rise. If the stock price continues to climb, the value of the put will fall. If you do not sell the put, you will lose the entire premium you paid to buy the put.
Stock has fallen in value but you still like its prospects. You will keep the shares as long as the stop is not hit on any pull back. If the underlying stock continues to fall, you can buy the put option to protect against short-term losses if you believe the company\'s long-term prospects are sound.
Stock has risen in value but you are concerned the market might turn down. The trailing stop will allow your profits to run if the stock price continues to rise, and will cut your losses if the market turns against you. If you believe the market\'s turn downward will only be short term, buying a put should be considered. This will allow you to hold on to your stock and insulate you against a potential downturn.
You wish to hold the stock for the long term and are willing to deal with drops in the price. You must either widen the trailing stop, reducing your gain, or accept that you will sell the stock on a pull back. You can always buy it back should the price fall further. Owning the put will allow you to hold onto your gain based on the strike price. You can hold onto the stock for the long term though there may be tax consequences from using a put. Some investors use the profit from the put strategy to buy additional shares of the company they like.
You wish to hold for more than one year to take advantage of long-term capital gains. Your stop loss does not change the holding period, though if the stop is hit before one year you will incur short-term gains on the sale of your stock. Buying a protective put can change your holding period for tax purposes. Check with your tax advisor to be sure.


Conclusion

Risk management is at the heart of any successful investor's strategy. By employing the right strategy, you can enhance your returns while lowering the risk of failure. Be sure to employ the appropriate technique for your situation.For related reading, take a look at Prices Plunging? Buy A Put! And Don't Forget Your Protective Collar.

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