Having a plan to preserve your gains and to manage your losses, should be the most important part of your investment strategy. I have noticed that most long term profitable investment strategies are not the ones with the best selection strategy, but the systems with a disciplined risk management strategy. A good example is the Bear market of the 2000-2002, which wiped out all the gains accumulated by the stock market since 1997.
The most commonly used risk and profit management strategy is to identify a target price. This target price(s) is used as a stop loss (e.g. to get out of the investment with a small loss) or to take your profit (e.g. exit the investment with gain). For example as an investor you decide that you will sell your investment if the stock you just purchased drops by $7, and exit your investment if it appreciates by 25%. You could rely on fundamental or technical analysis to determine your exit points.
Using fundamental analysis, you may have selected a stock with Price/Book ratio (P/B ratio) below the market's P/ B ratio, and decide that you will exit your investment if the stock's P/B ratio becomes greater than the market's. At this point, the investor believes that the stock is fairly valued. Using technical analysis, the investor may have identified a long term support level, and decides to exit the investment if the price drops below that level. One could use a combination of fundamental and technical analysis to develop his exit strategy. I explained some of these strategies in my previous articles.
A second method of protecting your portfolio or taking profit is use of index or equity options. Equity options give you the right to buy (call options) or to sell (put options) your investment at certain price by certain date.
Prices of the equity put options move in the opposite direction of the stock price. For example, an investor who bought a stock could purchase a protective put option, so that a drop in his or her initial investment is to some extent offset by an increase in the price of his protective put option. Prices of equity call options move in the same direction as the stock price. For example, if the investor has sold a call option on his stock, a covered call option, would pocket the premium if his stock moves sideways. In both cases you protect your initial investment using equity options.
Risk and profit management techniques are an essential part of any stock and fixed income portfolio. However, they require an in-depth knowledge of fundamental as well as technical analysis. In my next article, I'll explain protective put and covered call options in more detail, and tell you why it's the preferred method of profit and risk management.