Using protection

We use protection in so many aspects of our lives. We insure our cars, our houses, our lives – even our love affairs in the form of the Hollywoodesque “pre-nup”. Why do we do this? Because no matter how promisingly something starts out, human nature tells us that it could still go wrong down the track and we want to protect ourselves from that.

That’s why I’m constantly astonished that so few people insure their shares. There are few of us with a high enough tolerance for risk to refuse to insure our cars, yet plenty of us who throw vast amounts of money into the market without any kind of insurance at all.

Imagine you bought a new car for $30,000, and insured it for $1,000 with a $500 excess. If you crashed the car, the maximum amount at risk would be your premium plus the excess – $1,500, or 5% of your total investment. That’s a fairly low risk tolerance when compared to risks many of us take in the market – especially when you consider cars depreciate and are therefore a liability, not an asset.

We’ll experience more crashes on the sharemarket over a lifetime than we will in our cars (hopefully!) so it really does make sense to insure our shares as well. We can do this easily using put options.

A put option simply gives you the right to sell your shares for the agreed value (called strike price) at any time up to the expiry date. Simply put, it’s an insurance contract on the shares, whereby you pay someone else to take on the downside risk.

There’s no excess on this kind of insurance and the strike price is the same as the purchase price of your shares (assuming you buy them at the same time).

If the share price falls, you use this insurance policy to sell those shares at the same price you bought them for, limiting your loss to the premium you paid for the put option.

If the price stays the same, you can sell at the price you bought for, or buy further insurance to extend the protected period. Again your loss is capped at the premium you paid for the put option.

If the share price goes up – which is why you bought the shares in the first place – you make money. You receive all the upside profit, minus the cost of the put option.

Options don’t last forever. Just as you have to pay a new insurance premium every year to insure your car, put options also expire after a set period. In Australia, one put option covers 1,000 shares and this is the smallest unit you can buy. In foreign markets, options come in smaller and therefore more tailorable sizes.

Let’s look at an example. Say you buy 1,000 shares in The Widget Corporation at a share price of $10. At the same time, you buy one put option to protect the 1,000 shares at a strike price of $10 for 12 months, at a cost of $1 per share. This gives you the right – but not the obligation – to sell those shares at $10 any time over the next year.

Now, say the share price falls 50% to $5. You could exercise your right under the put option contract, selling your shares to the insurer for $10,000, minus the $1,000 you paid for the put option. So while your shares have lost 50%, you have only lost 10% of your original investment.

If the share price stays the same, you can extend the insurance period by buying another option, or you can sell your shares at $10. Again, your loss is the $1,000 you paid for the option – 10%.

If the share price goes up 50% to $15, you have made a $5,000 capital gain. If you sell your shares to lock in the profit, you have made a 40% profit – the profit minus
the cost of the option. As you can see, by insuring your shares you’re only risking the cost of the put option. This cost can be offset however, maximising your profit even further. How? By taking advantage of the second benefit of being a shareholder – dividends.

If the primary reason to buy shares is to share in capital growth through a rise in the share price, the second is to share in the company’s real profits via dividends. In our scenario, dividend payments can be used to offset the price of the put option.

Let’s see this in action in a real-life example:

In September 2005, I purchased 2,000 Westpac Banking Corporation (WBC) shares at $19.50 (for a total investment $39,000), and two WBC put options, expiring in June 2006, with a strike price of $19.50, at $1.15 per share (for a total cost of $2,300). My total outlay was $41,300.

That year, WBC paid a total divided of $1.52 - $3,040 for the 2,000 shares I had bought. So, even if the share price had fallen and I had exercised my put option, I would still have made a profit of $740, because the dividend income was higher than the price I paid for the put option.

What actually happened though, was that WBC shares rose to $25 before the put option expired. When we take into account the price paid for the put option, and the dividend income received, the total profit I received was $11, 740 – 28.4% of my original investment.

Had the share price fallen in that period, the most I could have lost would have been the $2,300 I paid for the put option, or 5.6% of my investment.

Capital protection is a sound cornerstone for a huge range of investment strategies, including constructing a focused investment portfolio, leveraged investing, active management and super.