Steven Smith
This column was originally published on RealMoney on Aug. 22, 2007, at 4:58 p.m. EDT. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.
In Scott Rothbort's recent article on how to handle market stress, he recommends getting rid of leverage
by paying down any margin balances in your portfolio .
He explains his reasoning by writing, "Leverage is a wonderful thing when the markets are going your way. However, during periods of increased volatility and declining markets, leverage can work against you ... and erode your portfolio much faster than if you did not employ leverage at all."
And he is absolutely right. Don't become a deer stuck in the headlights -- take some action to avoid being flattened.
He Who Hesitates Is Lost
I certainly agree that leverage is a double-edged sword, and traders who "lever up" in an attempt to boost returns must realize that the magnitude of potential losses also increases.
But it's worth keeping in mind that you can use leverage to reduce risk before volatility increases and positions turn against you. This, of course, could be accomplished by including options as part of your positions or portfolio to control losses from the outset.
The simplest strategy is the purchase of put options to limit the loss incurred if the price of the underlying asset declines. This is known as a married put. Like most insurance, it comes with a cost that will have a drag on returns. But thanks to the leverage of options, a small amount of money can buy you a lot of coverage.
The cost, like that of insurance, will, of course, depend on several factors. For example, the term or amount of time, because the longer the policy, the lower the annualized cost. Also, the condition of the asset being insured must factor in.
Rothbort suggests avoiding high-beta stocks, as these are thought to carry more risk. An analogy would be a house sitting on a fault line or a pack-a-day smoker, both of which will have higher insurance premiums. Finally, you must decide what size deductible or out-of-pocket loss you are to willing to accept.
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