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This article appeared in the September 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
Three techniques to help investors preserve gains and minimise losses.
By Julie McKay, Bendigo Wealth
After the latest sharemarket rollercoaster ride, capital protection is on everyone's mind. A capital protection strategy may give you peace of mind but don't equate it with insurance. There are two key characteristics that distinguish insurance and protection of financial capital.
First, insurance brings together a diverse group of people to spread the cost of protecting against events such as a house fire. Your insurance premium and good luck of not having your house burn down, pays for the damage suffered by someone less fortunate.
In contrast, a market crash affects everyone invested in the market. Risk cannot be spread across a diverse group to minimise costs, and can only be shifted to someone else prepared to take that risk. Like other financial assets, the cost of capital protection depends on the number of buyers and sellers of that protection.
Second, you are willing to pay for fire insurance because there is no benefit or reward from not being insured. Your house won't be more valuable without insurance, but if it burns down it will definitely be worth much less. In contrast, the laws of risk and return in financial markets are, by and large, absolute. If you shift risk to someone else, you give up some return potential.
The most common capital protection strategy is buying a put option, which gives you the choice to sell (or put) the underlying share to the other party at an agreed share price (the strike price). If the share price is higher than the option strike price, you won't exercise your option. If the share price is less than the option strike price, you will exercise.
Note that a put option becomes valuable to the option buyer when the market price falls below the strike price. This is the opposite of buying and holding the share itself. A share becomes more valuable as its price rises. Capital losses on your shares are offset by the gain on your put option. Conversely, capital gains on your shares are reduced by the cost of your put option.
The price you pay for the flexibility and choice of an option is called the premium. The more volatile the market, the more an option will cost. Also, the closer the strike price is to the current market price the more an option will cost. A put option with a strike price set at 90 per cent of the current market price will be more expensive than an option with a 50 per cent strike price. It is a little like an excess on fire insurance; if you are prepared to pay for some of the damage then your insurance premium is reduced.
The option premium is always payable upfront. However, some strategies effectively allow you to borrow the option premium and spread the repayment of that loan over the term. Most often you see this reflected in a higher interest rate. Part of the interest cost goes to repaying the loan for the option premium. Remember, if you need to get out of the investment before the end of the term you will need to repay the option premium loan.
Offsetting the cost
Paying a put option premium can sometimes appear expensive. The next strategy is to offset some of the cost by selling a call option. A call option gives the buyer the choice of buying (or calling) the underlying share at an agreed share price. But this time you are the seller of the call option. If the call option buyer exercises their option to buy, then you must sell at the agreed share price (or, more usually, pay the buyer the difference between the market price and the strike price). The call option buyer pays you a premium for selling this flexibility and choice.
Buying a put option and selling a call option over the same underlying share is called a collar. For example, you might buy a put option with a strike price of 70 per cent of the current market price and sell a call option with a strike price of 130 per cent. If the current share price is $10, your put option strike is $7 and your call option strike is $13. If the share price falls below $7 the value of your put option offsets the capital loss on the underlying share. The most you can lose is $3 plus the cost of the collar. If the share price rises to more than $13 the loss on your call option will offset the capital gain on your underlying shares. The most you can earn is $3 less the cost of the collar.
It is possible for the cost of the put option to be fully offset by the premium earned on selling the call option. The upfront cost may be zero but if the share price increases to $15 at maturity, for example, you will need to pay $2 ($15 minus $13 strike price) to the buyer of the call option, thus limiting your profit to $3.
Flexibility in CPPI strategy
There is a more complex capital protection strategy called CPPI - constant proportion portfolio insurance. Assume you have a $100,000 investment portfolio and want to protect three-quarters of that capital. As the value of the investment portfolio starts to fall toward $75,000 you shift more of your investment into cash. Conversely, as the value of the investment portfolio increases, you shift out of cash into the underlying shares.
Dynamic strategies such as CPPI are very powerful and can operate with a lot more flexibility than can be adequately described in this article. For example, some strategies have a rising floor. This means the amount of capital protected by the strategy increases as the portfolio increases in value. But note that the strategy behaves a lot like a put option.
In the simplified example above, the most you can lose is $25,000 but you retain any increase in the value of the investment portfolio. If it acts like a put option you can be reasonably confident it will be priced like a put option. Sometimes the option premium is called a protection or administration fee, or sometimes your upside is limited like the collar strategy. Unfortunately, sometimes the cost of the strategy is not easy to identify.
The other thing to note is that the strategy progressively shifts out of cash only after the market rises; the strategy misses some of the price upswing. A CPPI strategy performs best in a trending market but is not as effective in choppy markets. As the price falls, the strategy shifts into cash. This is good if the price continues to fall. If the price quickly reverses direction, then you have just sold at the bottom. As the price rises, the strategy will buy more of the underlying shares. This is good if the price continues to rise but the strategy might be buying at a peak if the price reverses direction again.
Capital protection can be a valuable strategy in many circumstances. The costs may be more than acceptable if you believe the market may drop at a time when you need to sell some of your portfolio.
The starting point for any decision should be your own financial circumstances. If you truly cannot afford to lose some of your capital, perhaps that capital is best put in a term deposit. If you have a medium to long-term investment perspective, perhaps you should not try to time short-term market moves but make your rebalancing decisions based on medium-term market expectations.
About the author
Julie McKay is senior manager, technical and research, Bendigo Wealth.
The ASX options course is designed to help investors understand the features, benefits and risks of exchange traded options, and introduce various options strategies - all in a stimulating, interactive learning environment.
The course uses latest e-learning techniques and technologies to deliver a format that has a small amount of text on one side of the screen and simple graphics or learning exercises on the other, to make learning easier and more enjoyable.
It includes education modules, summaries, and quizzes to test your knowledge, and even short movies with commentators explaining how they use options. There are also interactive tools that explain important options concepts, such as payoff diagrams, time decay, and pricing.
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© 2013 ASX Limited ABN 98 008 624 691