After months of trading sharply lower, July saw stocks like Lehman Brothers Holdings Inc. (LEH) and Bank of America Corporation (BAC) trade 80% higher over the course of just over a week. At the same time, energy names that had previously been solitary harbingers of strength (Goodrich Petroleum Corporation (GDP) or Chesapeake Energy Corporation (CHK)) saw their stocks drop 30 to 50%. Bear markets are notorious for being hard to predict and having some of the sharpest (brutal if you are short) rallies of any environment.

So if you are investing for gains and not cheap thrills, how do you shoot for attractive gains without stepping on a land mine and blowing up your hard earned savings? We often talk about using careful risk control or balancing out the potential reward against the risk of loss with each position. However, those are just empty phrases if you don’t have adequate tools to really evaluate and manage such risk. So here are a few lessons that should help in keeping the stress level low and hopefully the returns at reasonable and attractive rates.

Method #1) Stop Loss: Before putting on any position, you must already have an exit strategy in case you are wrong. I don’t care how lock tight your investment thesis is, there is always a chance that the trade will move against you. In order to survive over the long run, you must have an escape plan. I recommend starting with a 10% rule, but looking closely at the way the stock is trading. If there is a support area within 5% of your purchase price, it may not take the full 10% move to realize that you are wrong. Conversely, if you are trading a stock with extreme volatility, you may wish to start with a smaller initial investment, but give the stock 20% room to maneuver.

While it is extremely important to know at what point you will exit a losing positions, I’m not a big fan of entering a “good till cancelled” stop loss order with your broker. Too many traders see where these orders exist and can push stops through levels simply to touch off the orders and then buy the stock sending it higher. It makes more sense to set an alert if the stock reaches your level and then enter a market order to sell the position (or buy if you are short). However, if you don’t have the discipline to actually go through with the order when your level is reached, then a standing stop loss order is a better alternative.

Method #2) Own Options: Some traders use options as a means to benefit from a move in a stock while not getting hit with the full brunt of a losing position. Basically an option contract gives the owner the right (but not the obligation) to purchase shares at a certain level within a certain timeframe. So if Chesapeake Energy (CHK) is trading at $47.00, one may wish to purchase the September 45 calls. This gives the owner the right to purchase CHK at 45, but if the stock drops below that level, an investor only loses what he paid for the option, not the entire amount that Chesapeake as a stock could drop.

One common mistake (which can be quite devastating) when trading options is to put too much into any one position. If my portfolio is at a size where I would be comfortable owning 1,000 shares of CHK at $47, then I should only be willing to buy 10 contracts (each contract represents 100 shares). An investor who may put $47,000 dollars into a stock, but instead puts $47,000 into an option position may end up with an enormous gain, but he is also playing with fire in that it would be easy for his entire investment to disappear. Don’t be fooled by the low price of an option contract. Always understand the amount of underlying stock you are dealing with.

Method #3) Covered Calls or Covered Puts: This method takes a bit more study, but the basic premise is simple. A covered call position is set up so that the investor is willing to cap his potential gains and in return receives a partial credit against potential losses. The covered call position is simply long stock (assume 1,000 shares of CHK) and short a call option (10 September 50 calls for instance). In this scenario, someone might own CHK and sell September 50 calls for $2.00. Essentially the investor is accepting $2.00 against his position to help if the stock begins to lose value. At the same time, he is capping his gains at $50.00 since whoever owns the call will exercise the option to buy Chesapeake at expiration if the stock is above this level.

Covered Puts work in a similar fashion except the basic strategy is to sell the stock short and then sell puts against the position. If the stock moves lower, the investor is capping his potential gains from the stock he is short being profitable. But at the same time if the stock trades higher, he is able to keep the premium he sold the puts for to help offset losses in the stock.

No Free Lunch: It’s important to realize that every hedging or risk management technique has its drawbacks. With stop losses, there will be times that the stock moves low enough to stop you out of a long position and then turns around and trades significantly higher. There is nothing more frustrating than to watch a stock you used to own shooting for the moon. However, the time that you do not honor your stop level, you can be sure you will be hit with damaging losses.

Buying calls or puts outright have their own cost as one must pay an additional premium to get the exposure to the stock without the risk. Nothing is free. You wouldn’t expect the seller of that option to take the opposite side without being compensated for the risk he is taking.

Covered calls do allow you to collect premium on stock you already own, but they can cut short your potential gains. When selling calls or puts against an existing position, you must evaluate whether the premium you are receiving is justifiable considering the potential gains you are giving up.

There are many other ways to hedge or protect against losses. These are just a few to get you started. Our free-market economy and financial markets allow the creativity to add or take away risk in very unique and helpful ways. But one must always fully understand the entire picture that is in play when hedging or trading complex strategies. Banks and financial institutions could have used some of this foresight for the past decade. The bottom line is to always know what your exposure is, have a plan for positions that move away from you, and have the discipline to stick to that plan even when it is unpleasant.

Wishing you every trading success in this market,

Zach