A Different Beat - Option Talk
I remember it well. The floppy hair, the brightly coloured clothing, the outdoor music, the parties, the raves, the psychedelic memories. Not that I had any hair, I certainly chose quieter colours, my partying days were diminishing, raves appeared dangerous and illegal and I certainly didn’t get involved in anything psychedelic.
The nineties were a promising time - the economy was recovering from recession after the crash of 1987, ‘green shoots’ were emerging and technology advancement was gathering pace, but an ongoing European question troubled the politicians - to be in or out of the Exchange Rate Mechanism. It all sounds pretty familiar. I turned 30 years old in the nineties and my elders were telling me that everything happening was reminiscent of the sixties, down to the emerging Brit pop that came along later, with the concept of guitar led bands ruling the music world - that part I liked. I now find myself telling the youngsters that we may be replaying the nineties. Think about it…recovering from a crash, stuttering low growth, the European issue, Artificial Intelligence etc.
I remember the dilemma that faced fund managers – the fear of missing out. Do they buy equities in a rising market? Valuation was the key, but forecasts on capital growth could be skewed when projections for growth in different sectors of the market ranged from extremely conservative to outrageous. Which one was correct? Ironically many traditional stocks were sold in favour of high growth sectors, and the ‘clicks or bricks’ debate emerged.
The solution to the dilemma was often found in utilising traded options. In a conversation I had at the time with an options broker at a large US investment bank, he told me that a simple strategy was being used by many of their customers. Clients wanted to buy shares, but some of them couldn’t quite commit for the recent memories of crashes and corrections, yet every day they would see the market steadily rising as the management of the economy become more efficient. Cautious optimism emerged, with lower volatility and put premiums. So they would buy insurance with their stock purchases - a ‘buy stock buy put option’ approach. Fears of interest rates rising too quickly, overheating economies and markets and mismanagement plagued the bull run, but ultimately share prices kept steadily rising. When the Asian currency crisis triggered a short term correction in the late nineties, institutions found themselves partly protected from the falling stock prices with the put hedges.
The downside to this approach is the cost of the put options. Constantly renewing the positions every few months can be tiresome and costly, but investors found that the increasing dividend payments and increasing share prices outweighed the occasional outlays. Investors have to temper the insurance as they wish – when confidence grew, an investment decision can be taken to ignore the insurance – naturally higher risk.
Let’s take a look at a couple of examples in the UK market for illustrative purposes.
It’s currently the end of April and Vodafone shares stand at 212p; in the last few months they have been as high as 239.5p and as low as 190p. The shares are expected to go ex-dividend around 9p in early June, so the theoretical ex dividend share price is therefore 203p. An investor may want to protect themself in case the shares fall back and could look at the August 200 puts at 7.5p. If the investor buys the shares and the put option together the cost is 212 + 7.5 = 219.5p. The investor will profit if the shares rise above 219.5p. If the dividend is as expected, then in theory the book cost will reduce by 9p, so any movement above 210.5p becomes profit. However, if the investor is wrong, and the shares plummet to say, 180p, then the investor has a couple of choices. They can exercise the put and sell the shares at a guaranteed 200p. Considering the dividend payment, this would only create a loss of 219.5 - 9 - 200 = 10.5p, a significant advantage over the straight stock purchaser, who loses 23p. Alternatively the investor could keep hold of their shares in anticipation of the stock bouncing, and instead sell the put option, which would be valued at over 20p (200 – 180) still resulting in an overall loss of 10.5p (200 + 9 – 219.5.)
Aviva stand at 525p, the July 500 puts would cost 7p, and the next ex dividend won’t be until October. Buying the shares and the put would cost 532p, which becomes the breakeven for profit if the shares increase. If the shares fall, the investor has protection at 500p, minus the 7p, an effective selling price of 493p, so if for instance the share price moves down 10% to 472.5p, the investor will be in a better position than the stock purchaser who doesn’t own the put insurance.
Not recommendations, but an example of how this simple strategy could be used. However much the share price falls, the put purchaser would always have the safety net in place.
Remember to consider the charges and fees involved for both stock and option trades. Also be wary of dividend and expiry dates.
This article is not investment research and should not be construed as as an offer or solicitation to buy, sell or trade in any of the investments or asset classes mentioned. The value of any investment and the income arising from it is not guaranteed and can fall as well as rise, so that you may not get back the amount you originally invested. Nothing in this article constitutes advice to undertake a transaction, and if you require professional advice you should contact your financial adviser.
Walker Crips Stockbrokers Limited is a member of the London Stock Exchange and is authorised and regulated by the Financial Conduct Authority. Registered office: Old Change House, 128 Queen Victoria Street, London, EC4V 4BJ. Registered in England number 4774117
Important Notice
This communication has been prepared by Colin Bramble exclusively for AMT Futures Limited (AMTF) and its clients. These are views of the author at the time of publication and are intended to be for general information only. These views do not constitute any form of investment research, research recommendation, financial promotion or investment advice, nor should they be regarded as such. They should not be construed as an offer or solicitation to buy, sell or trade in any of the investments or asset classes mentioned. Further, they are not intended to promote or encourage any particular investment strategy or activity. [These views may not be consistent with the views of AMTF’s account managers.]
The value of any investment and the income arising from it is not guaranteed and can fall as well as rise, so that you may not get back the amount your originally investment. If you require professional advice you should contact your financial adviser.
This communication is compiled from sources believed to be reliable and every care is taken in its preparation. However, neither AMTF nor Colin Bramble accept any liability for any errors which may occur.
AMT Futures Limited Authorised and regulated by The Financial Conduct Authority