Insurance
An investor who is nervous about holding equities may like to use options to ensure the value of his holding so if shares fall, the overall value can be maintained. This would be impossible with only the shares but it is possible using options.
Trade
You retain your holding and buy put options which give the right but not the obligation to sell the shares at the exercise price at any date on or before the expiry date. You pay a premium just as you would for car or house insurance.
Assume you have a holding of 20,000 shares in a stock with a share price of 330p
BUY 20 JULY 300 PUTS @ 12p COST £2,400
Outcome on expiry
- Shares above 300pThe insurance policy was not required and the shares are retained. There is the chance that the shares have gone up and you participate in all this upside with the exception of the premium paid. The shares only need to go up by 12p or 3.6% to pay for the insurance.
- Shares below 300pThe insurance is now worth claiming on. You have two courses of action open to you.
Exercise the option.
Exercising the option would result in the sale of 20,000 shares at 300p. If you have a potential Capital Gains Tax problem then this should be avoided. ( Some of the options could be exercised to realise the CGT exemption.)
Sell the Puts
Because the stock is now below the strike price the options have intrinsic value. At expiry the options will be worth intrinsic value. You sell the options thus realising a gain which will compensate for some of the loss on the underlying shares. You have no need to realise the gain in your shares.
For example, assume the shares have fallen to 200p. You sell your options for 100p realising a gain of 88p per share or £17,600 whilst retaining your shares so as not to realise the larger gain.
The table below shows the value of the position with and without insurance.
| Stock Price | Value of Holding | Profit on Puts | Net Value |
|---|---|---|---|
| 200 | 40,000 | 17,600 | 57,600 |
| 220 | 44,000 | 13,600 | 57,600 |
| 240 | 48,000 | 9,600 | 57,600 |
| 260 | 52,000 | 5,600 | 57,600 |
| 280 | 56,000 | 1,600 | 57,600 |
| 300 | 60,000 | (2,400) | 57,600 |
| 320 | 64,000 | (2,400) | 61,600 |
| 340 | 68,000 | (2,400) | 65,600 |
| 360 | 72,000 | (2,400) | 69,600 |
| 380 | 76,000 | (2,400) | 73,600 |
| 400 | 80,000 | (2,400) | 77,600 |
Conclusion
As you see from the table above, you have protected the value of your holding in uncertain times to £57,600 but still participate in most of the upside. Total cost 3.6%.
Note
The above information is provided for illustrative purposes and should not be relied upon in making any investment decision, portfolio review or any other decision. No warranty or accuracy is given and you should obtain relevant and specific professional advice.
