Only Insure The Risks You Can’t Afford To Take

Everyone is trying to sell you something these days, and that “something” is usually insurance. Have you ever tried walking out of a mobile phone shop with your new phone and no insurance policy? Have you tried owning a dog without being bombarded with advertisements for the “essential” pet insurance that somehow wasn’t as essential when your parents owned pets?

Sometimes your possessions need to be insured, and sometimes your trading portfolio does too, but not every possession or trading position needs to be insured. In this article I’ll argue that in life and in trading you only need to insure the risks you can’t afford to take.

I’ll start with a “personal finance” analogy, which will turn into a trading lesson before the end of the article.

The Problem with Traditional Insurance

For most customers, insurance is a losing proposition with a “negative expectation”; it has to be so in order for the insurance companies — who hope to take more in premiums than they pay out in claims — to turn a profit.

If you added up all of the insurance premiums you ever paid over a lifetime on your car, home, illness, possessions etc., for most of you the total will be more than you had ever claimed back. Yet most of us consider insurance to be essential protection against unexpected events, and it’s an easy sell for the insurance companies who offer to “protect your bubble”… at least until it comes time to actually make a claim.

Not only do you almost always get less back than you paid in, but in the meantime the insurance companies have hold of your cash which they can “invest” wisely.

The Lure of Self-Insurance

Some people choose to “self-insure” by not paying the insurance premiums. They simply take the hit themselves in the unlikely event that something goes wrong. Each time you buy a hi-tech gadget, simply deposit the insurance premium in a bank deposit account rather than handing it over to the salesman over time you should come out ahead… even if you do occasionally lose a gadget. Let’s face it, after 18 months of ownership you’ll probably fork out for the new higher-tech model anyway, and consign your original now-obsolete model — on which you had taken the ‘essential’ 3-year protection — to the bottom drawer never to be seen again.

This approach works for those risks where you can afford to take the occasional hit. Most of us can afford to replace a £300 phone occasionally, can’t we? And the £100 saved from not paying the insurance premium would help us to do just that. Do we really need to provide the AA, RAC, or other motoring organisation with a continuous revenue stream when we can pay for a tow truck only when we really need one?

It’s a little different when we consider the potential liability of knocking someone down in our cars, or the cost of rebuilding our detached houses. Some risks we simply can’t cover from spare cash. In those cases, and unlike most gadget insurance, the typical motor vehicle or home insurance premium is usually very small compared with the amount of cover.

My point is that it is probably most cost-effective to insure only those risks which we can’t afford to take.

Stop Orders as an Insurance Policy

When you apply a stop order to an open position, you run the risk of stopping out and having to re-enter the position at a higher price (or bank the loss forever). That’s the price you pay for insuring that you don’t hold all the way down to zero. If you guaranteed the stop order, you will have paid for the privilege by paying an additional fee that is not unlike an insurance premium.

As I argued in my article Price Gaps and Guaranteed Stops, when I took a £1-per-position in Admiral Group at around 800p-per-share in my small £1000 account, the prospect of losing several hundred pounds on any unexpected 50% gap-down was simply too much risk to take… so I considered the guaranteed stop ‘insurance’ premium to be well worth the money.

On the other hand, when taking a token position at £1-per-point on a low-price stock like Yell group (I could name many more) at 5p-per-share, is it really worth risking stopping out at 3p-per-share let alone guaranteeing your ability to do so? In the absence of any stop order, the maximum risk is only £5 thanks to the low price and small position size. You can afford to take this risk, so you don’t need to insure it with a stop order.

Review Your Insurance Commitments

Next time you purchase a phone, computer, house, car or pet think carefully about whether you really need the “essential” insurance. You might also review your existing insurance commitments in order to find out, for example, whether you’re still paying for travel insurance when you never actually go anywhere.

Next time you open a new spread bet position, think about whether you really do need a stop order. Are you attaching a stop order merely out of habit, or because the potential risk really is too big to bear. Note: when placing a £100-per-point on the FTSE 100 index at a price of 5000+, this risk is definitely too big to bear!

If you hold many simultaneous positions like I do, you might go through each one to determine whether any of them are at risk of stopping out at a small loss — and obliging you to re-enter on less favourable terms — when the bigger loss of a total wipe-out is perfectly manageable.

By all means use stop orders as an insurance policy, but only insure the risks that you can’t afford to take!

Tony Loton is a private trader, and author of the book “Stop Orders” published by Harriman House.