Low-Cost Insurance

How to minimize downside risk while retaining upside potential.

How to minimize downside risk while retaining upside potential. When the market is headed for a downturn and you own long-term core shares, what can you do to protect those positions?

How to minimize downside risk while retaining upside potential. When the market is headed for a downturn and you own long-term core shares, what can you do to protect those positions? You could hedge the share by selling low-quality shares short (high risk to the upside), you could buy put options (large out-of-pocket expense), or you could try to “short against the box” (being long and short the same share at the same time, if the broker allows it). Each of these alternatives has its pros and cons depending on the investor and current market conditions. However, there is a better way. We call it our “Low-Cost Insurance Policy”.

Suppose you own 1000 shares of a share like Intel (INTC) and you do not want to sell INTC in a downward trending market. At the same time, you’re not crazy about riding the gut-wrenching ups and downs that INTC might have during volatile market periods. A terrific way to offset the risk inherent with INTC’s gyrations is to sell an out-of-the-money covered call option and use the premium received to buy an out-of-the-money put option.

As an example, let’s say that INTC is trading at $110 per share. If you were to sell the April 120 call option, the Black-Scholes Option Valuation model (found in VectorVest ProGraphics) says you would receive $7.13 per share (as of 2/17/00) per call option. This means you would be paid $713 per call option. Since each call option controls 100 shares and you own 1000 shares, you would sell 10 call options for about $7,130. This premium is deposited to your brokerage account.

As the next step in our Low-Cost Insurance Policy, you would buy the April 100 put option.

This means you are buying the right to sell INTC at $100 per share until expiration in April. If INTC were to drop in price, this put option would increase in value. If INTC were below $100 at expiration in April, then the put option would have some value left, but if INTC were above $100 at expiration, the put option would expire worthless.

The April 100 put option had a value of about $5.49 per share per put option contract. This means the April 100 put would cost about $549. Again, since you own 1000 shares of INTC, you would buy 10 put options for a cost of $5,490. Where is the $5,490 going to come from? Well, you received $7,130 from the sale of the call options so you can use that toward the cost of the put options. And you still have $1,640 left over! Let’s recap the numbers so far.

As of 2/17/00: Purchase 1000 shares INTC @ $110 per share.
Sell 10 April 120 call options at about 7.13.
Buy 10 April 100 put options at about 5.49.
Credit to trading account: 1.64 points ($1,640).

With any option strategy it’s a good idea to play “what if?” with the prices to see where your gains and losses are maximized.

Case 1: Big drop in share price.

What would happen if INTC dropped to $70 per share at expiration?

Since the share price is below the call option strike price of 120, the call option expires worthless (profit = $7,130).

The put option is now in-the-money by 30 points, so at expiration the put is worth 30.00. Remember, you paid 5.49 for the put, so your profit on the put option is 30.00 - 5.49 = 24.51 (profit = $24,510 for 10 put options).

So far, so good. But the share has a loss of 40 points ($110 - $70). On 1000 shares this is a loss of $40,000. Let’s add it up:

Case 1 summary:
Profit on call option: $7,130
Profit on put option: $24,51
Loss on long share position: ($40,000)
Total gain or (loss): ($8,360)

In other words, if INTC were to drop 40 points by the third week in April, you would realize a loss of only $8,360 or 7.60% versus a $40,000 loss, or 36% loss, holding the share alone. This is your maximum loss on the position. Clearly the Low-Cost Insurance Policy did its job.

Case 2: Big increase in share price.

What if INTC were to shoot up to $150 per share?

The call option would certainly be exercised and your INTC share would be called away at $120. Since you own the share at $110 per share, this is a profit of $10 per share, or $10,000. You would not participate in the profit above $120 per share.

As the seller of the call option, you are entitled to keep the option premium you received when shorting the call. You keep the $7,130.

Since the share price is now above the put option strike, the put is out-of-the-money. Therefore, the put option expires worthless. Loss of $5,490.

Case 2 summary:
Profit on call option: $7,130
Loss on put option: ($5,490)
Profit on long share position: $10,000
Total gain or (loss): $11,640

Here we gained 10.58%. This is your maximum gain with the Low-Cost Insurance Policy.

Case 3: Unchanged.

Finally, what if INTC stayed at $110 per share until expiration?

The call option would expire worthless since the share price is below the strike price. Therefore, you would keep the $7,130 premium.

The put option would also expire worthless as the share price is above the strike. Therefore, you would lose the $5,490 you paid for the put option.

The share is unchanged with no gain or loss.

Case 3 summary:
Profit on call option: $7,130
Loss on put option: ($5,490)
Long share unchanged: ---0---
Total gain or (loss): $1,640

Even if INTC does absolutely nothing until expiration, you can still make money!

This strategy is very similar to what is known as a Synthetic Short Sale. With a true Synthetic Short sale, you would buy the put and sell the call with the same strike price. However, by splitting the strike prices above and below the share price, you have the potential for upside profit with substantial downside protection.

The Low Cost Insurance Policy is a terrific way to reduce your downside risk on a long share position with minimal cash out-of-pocket. It should be considered whenever you are concerned about price declines on your core holdings.