Addendum: Friday morning. The soaring futures coupled with yesterday's rally may seem to make this discussion moot. But it doesn't. Volatile markets make the need for risk management more apparent, but it's necessary in all markets.
This has been the most volatile week in stock market history – as measured by total point moves in the DJIA. That includes declines of 504 and 449 points, and rallies of 160 and 410 points.
After the declines, the words 'don't panic' were everywhere. The talking heads on business stations and financial journalists are telling people not to panic. The TV news anchors are doing their best to interview 'experts' to explain what's been happening.
The advice not to panic is sound – because selling in panic mode is seldom a good decision. If you carefully consider alternatives and then decide to sell a portion of your stock investments, that's not a panic. That's a reasoned decision. But whether anyone should sell is beside the point. I don't believe that most investors should be in this uncomfortable position in the first place. Losses could have been minimized, or even eliminated.
What bothers me about the 'don't panic' advice is that everyone has advice on what to do now. But the black swan has appeared, the markets have tumbled, and its too late for that advice. What investors needed (and still need) to know is how to protect their portfolios -now and in the future – so there's no need to panic. Their investments would have been safer and losses would have been a fraction of current losses.
Financial professionals generally offer sound advice on investing. But when discussing risk management, the primary recommendation is telling investors to diversify. That's good advice, and should not be ignored, but it's not enough.
There's a better technique available to millions of individual investors - hedging. Don't let that word frighten you. To hedge means making an investment that offsets all, or part, of the risk associated with holding another investment. The easiest way for the average investor to accomplish that task is to use options.
'Options' is a term that frightens the uninitiated, and financial professionals are rightfully concerned about introducing options to their readers, viewers or listeners. Why is that? Because too many option rookies begin using options before they understand how they work. It's human nature to hear about a useful tool and put that tool to work immediately – before being prepared. Instead of hedging, many use options to gamble, and lose their money. Such losses gives the entire options industry a bad name.
Learning to use options is like anything else – it takes a little time and effort to gain an education. It's not difficult to learn, but neither is it instantaneous.
I know that investors can benefit by understanding risk-reducing option strategies. I've been making an effort to fill that education gap, and this blog is a primary example. I also run a website and have written many magazine articles and three books about options for beginners.