What is Limited Risk?

In finance, limited risk describes any investing strategy intended to protect an investment or portfolio against loss. Limiting risk usually involves securities that move in the opposite direction than the asset being protected.

How Does Limited Risk Work?

Let's assume part of your investment portfolio includes 100 shares of Company XYZ, which manufactures autos. Because the auto industry is cyclical (meaning Company XYZ usually sells more cars and is more profitable during economic booms and sells fewer cars and is less profitable during economic slumps), Company XYZ shares will probably be worth less if the economy starts to deteriorate. How do you limit your risk?

One way is to buy defensive stocks. These stocks might be from the food, utility, or other industries that sell products that consumers consider basic necessities. During economic slumps, these stocks tend to gain or at least hold their value. Thus, these stocks may gain when your XYZ shares lose.

Another way to hedge is to purchase a put option contract on the shares (this would essentially allow you to 'lock in' a particular sale price on XYZ, so even if the stock crashed, you wouldn't suffer much). You could also sell a futures contract, promising to sell your stock at a set price at a certain point in the future. You could also limit your risk by using index options.

You can measure limited risk. The term delta, for example, describes how much the price of an option will move for each $1 change in the price of the underlying stock. (Delta changes with every change in price, volatility, and time to expiration; but for small to moderate changes, delta is a good approximation of the price change you're likely to see in an option.)

Why Does Limited Risk Matter?

Placing limited risk in a portfolio is like buying insurance. It is protection against unforeseen events. This is why portfolio hedging is an important technique to learn. Although the calculations can be complex, most investors find that even a reasonable approximation will deliver a satisfactory hedge. Hedging is especially helpful when an investor has experienced an extended period of gains and feels this increase might not be sustainable in the future. Like all investment strategies, limiting one’s risk requires a little planning. However, the security that this strategy provides could make it well worth the time and effort in a period of declining stock prices.