You may have heard that Green Mountain Coffee Roasters stock took a big hit earlier this week when they missed earnings and put out a disappointing forcast for the remainder of the year. In fact, the stock lost almost 48% of its value in one single trading day. Ouch! Now if you have been long the stock, that is a major hit to that portion of the portfolio. Granted GMCR has been a momentum stock for some time now, so it isn’t unexpected that the gains would slow at some point. However, it can still make for some sleepness nights knowing that one day could wipe out so much value.
Sleep Better At Night–Buy Some Protective Puts
If you are investing in the stock market (and especially in individual stocks), you need to have some plan for these events when they occur. There are many ways to do this from not buying individual stocks and going only with indexes, to diversifying across several stocks and sectors, to using stop losses, to buying put options. I would like to address the concept of risk management from the perspective of put options and share what I do with my retirement account.
If you have been reading this blog for a while, you know that I invest my retirement account in some individual stocks many of which might be considered risking (ironically, GMCR only shows a beta of 0.8). Take for example, my investment in Onyx Pharmaceuticals (ONXX). This is a stock that I bought after selling Imclone which was bought out several years back. I purchased ONXX as a potential buyout candidate for which there is still potential. The most recent run up is due to buyout rumors again.
Over the past year, ONXX (with a beta of 1.2) has traded from $27.17 to $47.80 per share. With this most recent pop, I decided to buy some protective puts at a strike of $46 expiring in the month of May in two weeks. So far, that looks like a good decision since ONXX is now back down under $43 per share. Since my overall cost in the stock is $43.57 even after the purchase of the puts, I have guaranteed myself a profit.
Then, I will be able to purchase back the same stock for less and either sit on the cash or purchase even more shares of ONXX in preparation for the next pop. I will usually pay for the put options by selling some covered calls creating a collar.
I have found the technique of buying puts, selling calls or selling stock when it pops and buying back calls, exercising puts, and buying more stock to be fairly effective in mitigating losses and decreasing volatility in my retirement portfolio.
Hopefully, I won’t one day discover that the stock that I am holding has dropped by almost 50% in one day. But if it does happen, I know that I will sleep well because I would have owned some protective puts.
Oh, and by the way, a stop loss order would not have helped with GMCR this week. If you don’t know why, be sure to ask.
Readers: I am guessing that most of you use indexes for your risk management, but for those who do pick individual stocks, what do you do?