The fear of commitment may be a bugbear for some and it’s often not just confined to relationships. Committing to buying a share can be as scary. Sometimes the decision to jump in to buy a share can evoke emotions that are as intense as committing to a relationship. Shall I or shall I not? Especially for a share that has plunged in large percentages. The tug of war of wanting to jump in and at the same time negotiating an equally real and opposing emotion of the “what ifs” certainly play havoc in the minds of investors.
How do you protect yourself from making a wrong decision in your commitment? How do you commit with an exit door prepared? How do you commit but not yet totally? These are some of the questions that may bug us before making a considered commitment. Though solutions may not come readily in life situations, in the investment domain the good news is these solutions already exist.
Often the more volatile a share is, the more we are drawn to it for its potential gains. One such volatile share that comes to mind is Macquarie Group. Its pre-GFC price was sub-$100; during the GFC its price was sub-$20 and now about three years after GFC; its price is sub-$36 having fallen 16% just three weeks ago. Fear of committing to such a volatile share? You bet. But there are strategies we can employ to allow us the exposure and yet be protected from those down swings.
A common way of protecting capital and stopping losses for an investor is to sell the shares. Other than the cost of selling shares and the capital gains/loss implications, the biggest weakness of this solution is that it cannot be pre-executed. We can make a mental note, set alerts or even tell our broker of the intended price to exit to cut losses, but for it to be done, it has to be manually executed or sold, after the exit or alert price has been triggered. This post-event execution gives room to change of mind (talking ourselves out of taking losses) or the opportunity to lower the pre-determined stop loss price (which potentially widens losses). Even in situations where the investor has a mind of steel and is disciplined to stick with the original trading plan, the exit price of those shares still cannot be guaranteed; the share could gap down before reaching the exit or alert price.
What else can an investor do? Use options to manage downside risks. Options can take emotions, luck and human intervention out of the equation. Options strategies can pre-determine potential maximum losses and pre-set a guaranteed exit price for cutting losses. The investor buys the right to execute his wishes at the intended price for a later date. The two options strategies that achieve those objectives are the buying of call options and buying of puts (at the time of share purchase or for existing shares in the portfolio).
Buying of call options is often used by many traders as a way of gaining leverage to the underlying share by paying a fraction of the total price. The intention of the buyer is to trade a view cheaply and magnify the potential gain if the view turns out right; if not, a limited amount is lost. However, for an investor who shares the positive view but is prepared to buy the shares as part of a portfolio, the buying or call to buy shares strategy protects capital by spending just a fraction at the first instance with the rest earning interest until required, plus giving the holder the right to walk away if the positive view does not eventuate.
What about a guaranteed exit price? Buying of put options over shares held is the only way an exit price can be guaranteed. The exit price is locked in before the share falls, with the payment of a premium. This strategy does increase the cost price of a share but if protection was not needed the shares are still intact. The investor would not have missed any dividends if there were any during the period and need not have endured the extra cost of re-buying the shares at a future undetermined price.
There is yet a third strategy in the options market that overcomes the cost of hedging above. Investors can be paid for making a commitment. This strategy is the selling or writing of put options. Instead of buying shares now, the investor merely commits to buying shares at a chosen price later if asked to do so and for this commitment, is paid a premium.
Strategies two and three above when used together, are most cost effective for gaining exposure with protection to a share such as Macquarie Group, which is volatile, but attractively priced with the lure of a juicy upcoming dividend. This is the bull put spread strategy where the selling of put options is accompanied by a simultaneous buying of put options at a lower strike. With the share going ex-dividend in three months, the investor will be looking at a put spread for two months for the potential of buying the shares just in time for dividend.
Below is a summary of the trade.
With the use of the bull put spread strategy above, instead of walking away from a commitment, an investor can now take the plunge with peace of mind and say, “I do,” confidently.