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Portfolio Protection using Options

Introduction

The swings in the market often expose investors to risk of loss. Some of these exposures necessitate investors to protect their portfolios with an aim of minimizing losses. This can be achieved by using several strategies. The paper will focus on describing two option strategies that can be used to protect a portfolio. These two strategies are described below.

Put option

A put option can be used to protect a portfolio against a possible decline in the price of shares. This option will grant the investor (buyer) a right to sell the stock in the portfolio at a predetermined price. The time period of a put option is fixed. If the market price of the stock in the portfolio falls below the strike price (agreed upon price), then the investor can exercise his/her rights to sell at that price and the writer has an obligation to buy the security at the strike price. In this case, the investor will make a profit that is equivalent to the difference between the market price of the stock in the portfolio and the strike price (which is higher than the market price of the stock) at the end of the three months (Gitman, Joehnk & Smart, 2011).

For instance, if the stock in the portfolio is currently trading at $80 and the investor currently holds 200 shares. A put option contract with a strike price of $80 that is expiring in four months’ time is priced at $4. It is expected that the share price of the stock will drop in the coming three months. Therefore, a total of $800 ($4 * 200) will be paid to buy single put option that covers all the stock in the portfolio. Assume that the price of stock plunges to $60 at the end of three months as anticipated. If the investor exercises the put option, then he/she will invoke the right to sell the stock in the portfolio at $80 for each share. At this point in time, the investor does not own any shares in the portfolio. However, the investor can buy the 200 shares in the open market at $60 per share and sell them straightaway at $80 per share. Therefore, the investor will earn a profit of $20 per share ($80-$60). The total amount of profit for the 200 shares will be $4,000 ($20 * 200). This represents the amount that the investor will receive if he/she exercises the put option. As earlier mentioned, the investor paid a sum of $800 to purchase the put option. Therefore, the total net profit earned by the investor will be $3,200 ($4,000 – $800). The analysis shows that the strategy will enable the investor to retain the value of the portfolio.

Collar strategy

This strategy also provides a way of protecting the portfolio against a possible decline in performance. It works by locking the maximum gain and maximum loss of a stock. Further, it combines both put and call option. For the strategy to work, the two options need to have the same date of expiration. Also, the strike price of the call option needs to be higher than that of the put option. This will enable the investor to gain when the price of the stock increases or drops. Also, the two options should not have an intrinsic value. They should have a time value (Abumustafa, 2007).

From the previous example, the investor has 200 shares in the portfolio and the market price of each share is $80. The total cost of the shares is $16,000 ($80 * 200). In order to buy a proper collar, the investor needs to buy a put with a strike price of $76 and sell a call option with a strike price of $84. The two should have a similar expiration date. Assume that the investor buys a call option at a cost of $2 and the put option at $1. If the investor sells the call option, then the total cost of the put option is $200 (200 shares * $1). On the other hand, the total amount that the customer will receive from the sell option is $400 (200 shares * $2). After three months, if the market price of the share falls to $70 per share, the total cost of the shares will amount to $14,000 (200 shares * $70). Thus, the amount of the loss will be $2,000 ($14,000 – $16,000). However, with the protective put option, the investor is able to sell the shares for a total of $15,200 ($76 * 200) instead of $14,000. This reduces the amount of the net loss to $1,000 ($15,200 – $16,000 – $200) instead of $2,000. If there are no changes in price of the stock at the end of the three months, the investor will still make a profit of $200. If the price of each share rises above $80, the investor will exercise the call option and make a profit. Therefore, this strategy allows the investor to maintain the value of the portfolio in case of both favorable and unfavorable swings in the market (Dewobroto, Febrian, Herwany & Brahmana, 2010).

References

Abumustafa, N. (2007). Hybrid securities and commodity swaps; tools to hedge risk in emerging stock market: Theoretical approach. Journal of Derivative & Hedge Funds, 13(2), 26-32.

Dewobroto, D., Febrian, E., Herwany, A., & Brahmana, K. (2010). The best stock hedging among option strategies. Research Journal of Applied Sciences, 5(6), 397-403.

Gitman, L. J., Joehnk, M. D., & Smart, S. B. (2011). Fundamentals of investing (11th ed.). Boston, MA: Pearson.

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