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chapter2/2 minimize risk

Chapter 2

Minimize Risk

Many investors put a substantial part of their life savings into stocks. These purchases can easily amount to many thousands of dollars. Every dollar put into the stock market is subject to risk. When we buy a substantial asset such as a house, a car, or even jewelry, we insure that purchase against loss. But investors frequently invest in stocks without any insurance at all.

The purchase of stock options can be used to insure against loss when buying or selling stock. Like car insurance, options have a fixed term. The buyer of a stock can buy puts to protect against a decline in the stock price. If the stock goes up, a profit is realized in the stock. If the stock goes down, a profit is realized from the put, offsetting the decline in the stock price. This strategy insures against large losses, but incurs a premium that increases as the term of the put increases.

Similarly, the short seller of a stock can purchase a call to protect against losses if the stock value rises.

 

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