Investment decisions are normally made based on an emotional response. As a professional advisor, I need to remove all emotion in the decision making process. To do this, having a broad understanding of how the stock market works helps alleviate uncertainty. But having an in-depth knowledge of the available strategies provides a course of action to hedge against possible stock market crashes.
Predicting what a stock price is going to do is an unrealistic expectation. Analysts will calculate an expected price target based on numerous factors. But just because a company may be deemed fundamentally strong, does not necessarily mean the share price is going to rise at any given time. It is the random nature of markets and the uncertainty that causes Risk for investors.
Did you know that you can adopt strategies that provide a means to make a profit from a share price falling?
Most people I make this statement to think I am peddling snake oil, or trying to sell them into a Ponzi Scheme. But through licensed brokers, regulated by the stock exchange, you can buy and sell stocks and or options that provide you with the ability to benefit from a fall in a stock price or the broader stock market. Of course, if you get the direction wrong and prices rise, you will lose the capital you have invested into that position just the same as if you had bought shares and the share price had fallen.
Strategy is the key here. If you are a share holder, your Risk is that the share price might fall in value. But if there were a strategy you could adopt to ‘hedge’ against a fall in stock price, would you be interested?
Anyone who has experienced a stock price falling, or any of the recent stock market crashes such as the Global Financial Crisis, Currency Crash or Tech Wreck are more than familiar with the emotional responses they experienced.
Exchange Traded Option – ETO
There is a product available through nearly all major stock exchanges known as an Exchange Traded Option (ETO). There are two types of ETO’s: a Call Option and a Put option. If you are a share owner and you are concerned your shares might fall in value, then it is the Put option that you can use to help protect the value of your position.
Put options are a contract that provides the holder the right to Sell their shares at a set price, on or before a set date. That’s right, you have the right to sell your shares at an agreed price! To own this contract, you will pay a premium. The more time you want to own the Put option, the higher the premium.
These options are standardized in terms as stipulated by the stock exchange. This makes it much easier to distinguish a ‘fair’ price for the option, and in management of exercising the option terms for shares to change hands.
Let’s discuss a simple example. Let’s say you own 100 shares in XYZ and had purchased these at $20.00 per share. Current price for these shares is $22, but you are concerned the share price might fall over the coming two months. For this reason, you decide to adopt a Risk management strategy by purchasing Put options.
We’ll choose a Put option with a Strike price of $20. This means you have the right to Exercise the position anytime before expiry of the contract, selling your shares at $20. Although the share price is currently at $22, you are willing to assume some Risk that the share price might fall, but not lose much of your original investment capital.
The time until expiry of this contract is 3-months. We’ve decided to ‘buy enough time to be right’. Each Put option contract is standardized in that it represents 100 shares, so we only need to buy 1 Put option against our 100 shares in XYZ.
The cost of buying this $20 Put option is say $0.80 per share. This means our breakeven for our total position is $20 (share buy price) + $0.80 (option buy price) = $20.80. If the share price closed below $20, however, we can Exercise the terms of the option, Sell our shares at $20 for a total Risk of only $0.80.
No matter what price the share might fall to during the time of the option contract, we have locked in a sell price of $20. And as long as XYZ remains above $20.80, our position is profitable.
Buying Put Options
Buying put options against shares is one strategy that the investor can use to offset a fall in value with their share position. If you own numerous shares, you may be able to purchase Put options on an index that represents the shares that you own. This means purchasing Put options in the one underlying, and not in an array of different stocks. This reduces costs whilst still providing the protection required against a broader stock market fall.
Other strategies are also available, that provide exposure to markets in different means. ETO’s are certainly a product that require study and a higher level of stock market understanding. For this reason, we recommend you seek the services of a licensed Derivatives advisor.
Buying Put options incurs a cost, also known as Premium. The concept is no different to when you buy Insurance for your car or house. You pay a premium for the right to exercise the terms of the contract. If you have no need to fulfil the terms, the contract lapses. Of course, you can renew the contract, paying another premium.
Put Options Strategy
Put options are the simplest strategy you can adopt to hedge your stock portfolio against a stock market crash. If the average investor was aware of this strategy, there would have been many people who could have offset the massive declines that occurred during the Global Financial Crisis. Just like any insurance, having the right policy to suit your needs is imperative. They are a piece of mind, that many stock investors would love to have.
Matthew Brown – US Stocks & Options specialist
US Equity & Option Client Advisor
Halifax Investment Services
ASIC Australian Financial Services License Number – 225973
Matthew is an Authorised Representative of Halifax Investment Services (Halifax). Halifax provides broker services, including Full Service and Discount Services using multiple trading platforms.