Stock Insurace: 3 Strategies to Limit Stock Losses

By Adam Hayes
culled from:http://www.investopedia.com

People protect their largest assets by buying insurance on their home, cars, expensive jewelry and even their lives. Much the same way, investors can use derivative securities to effectively buy insurance on their individual holdings or on their portfolio as a whole. Although derivative securities may seem risky, when used properly they function in exactly the opposite way – to reduce risk and insure against loss. One can also use order-management strategies such as a stop loss order. (For more, see: Are My Investments Insured Against Loss?)
Using Futures to Hedge
Futures are derivative contracts that obligate the owner to purchase the underlying asset at a specified fixed price and at a specified future date. Likewise, the seller of a futures contract has the obligation to deliver the underlying asset at that price and time. Of course, in the majority of cases traders close out their positions buy selling a long position or buying back a short position prior to expiration as not to take delivery.
Although there isn't much of a market in futures on individual stocks, there is a large and highly liquid market for stock index futures. If an investor's portfolio largely resembles an existing equity index such as the S&P 500, Nasdaq 100 or Dow Jones Industrial Average, or if they are passively invested in an indexed strategy they can use futures contracts to insure themselves against a drop in market value.
Suppose an investor owns a portfolio that consists of a large amount of SPDR S&P 500 ETF (SPY), and she anticipates a decline of at least 10-15% in the price of the index at some point in the next six months, but she does not want to sell her position outright (perhaps due to tax considerations, to avoid transaction costs, or because the strategy prohibits holding large cash positions etc.). She can sell enough futures contracts that expire in six months to cover her portfolio value.
In our example, four months later the S&P 500 declines 15%. Her portfolio value has lost 15% of its value, but the futures contracts that she sold have also declined by the same amount. She can then buy back those futures to cover at the lower price, and her resulting loss is net zero. If her portfolio was left unhedged, she would be down the full 15%. In this hypothetical example, the hedge fully protected the portfolio against a decline and she preserved the value of her portfolio despite a significant decline in the market of 15 percent. But, if the market had risen, the portfolio's gains would have been exactly offset by losses on the futures contracts. If the market were to rise instead of fall, our investor would have had to consider removing her hedge by buying back the short futures contracts at a higher level. (For more, see: A Beginner's Guide To Hedging.)