Protective puts: Strategy guide

Key features

• Ability to borrow up to 100% of a share you own
• Investors have unlimited upside potential plus all dividends and franking credit entitlement
• Downside risk is limited to the cost of the insurance premium (cost of put option) plus holding costs (interest expense)
• Peace of mind to buy into the market during turbulent times without trying to pick a market bottom

Over the last couple of years some investors have moved to the sidelines due to market uncertainty. On the other hand, some savvy investors have taken advantage of the market dips while protecting their investments using a protective put strategy.

This strategy is suited to investors who want peace of mind by limiting their downside risk while still taking advantage of the upside potential and higher equity yields.

How does it work?

A put option acts like an insurance policy for the shares you wish to protect. Put options are traded on the ASX and can be purchased just as easily as any share.

You choose:

1. The price you wish to protect your share at (the option strike price); and
2. The expiry date when your insurance will mature (the expiry date).

Should the share you purchase decline in value, you will have the option to sell the share at the protection price (your chosen put strike price) anytime up until the nominated expiry date, regardless of where it is trading on the market. Like any insurance product, you will pay a premium for this added security.

However, high dividend yielding shares may help reimburse you part of these costs once the dividend is paid.

If you purchase shares along with a protective put through your Leveraged margin loan, we’ll provide you with an increased Loan to Value Ratio of up to 100% of the strike price of the put. This is because you are fully protected at the strike price as long as you hold that put, preventing a margin call even if the stock price falls significantly.

If the share increases in value, you’ll receive the profit from the rise in the stock value as well as any dividends, franking credit entitlements, and tax benefits you may be entitled to by borrowing to invest.

This strategy gives you access to all the benefits of the underlying share while limiting your maximum potential loss to the price of the put plus any interest expenses paid to hold the position.

Here is an example using real prices:

If you choose to use the Leveraged 100% gearing, available under the Exchange Options Plus feature you will need to invest $6,500 to cover the cost of the put plus brokerage and any interest costs to hold the position through the margin loan.

This will give you exposure to $73,000 worth of Company A shares. The total dividend over the 227 days of the put is equal to $4,200 + any franking credits you may be entitled to, which covers a large part of the put protection and removes any equity risk you had on the position.

Things to keep in mind

Please be aware option prices will always vary as the underlying security changes in price.

Investors also have the choice to buy a protective put below the current trading price which would reduce the cost of the put protection.

What happens if the stock declines in value?

Let’s assume the shares in Company A declines to $60 after the purchase, but before the expiry date. Investors could take the following steps:

1. Sell the shares at the strike price of $73 and receive a credit to their account for $73,000. They can do this by selling the put and stock on the market or by exercising their put through their broker. The $73,000 will be used to pay back the loan.
2. The client now has the ability to buy the shares again at a lower price of $60 per share. They can continue to repeat steps one and two until the stock increases in value.

Given investors have the ability to borrow 100% at the protective put strike price, they have the choice to gain a leveraged exposure to the underlying share just by purchasing a put. Their downside risk is limited to the cost of the put plus any holding costs incurred and less any dividends receive.

Take advantage of a sharp fall

Should Company A drop to $60 and then increase in value to $80 and the investor rebalanced their portfolio at $60 their profit would be:

Investors can also choose to protect their portfolio for peace of mind without rebalancing their portfolio as it falls. This means clients will not go into a margin should the stock fall although clients can choose to sell out at any time.

What happens if the shares remain flat?

Here the put would expire worthless and the investor will continue to hold the stock. The investor would incur the cost of the put less any dividends received during that period. Investors also have the choice to sell a covered call in combination with the protective put to generate an ongoing income in a flat market.

While the best time to buy into the market is when prices are low, this is usually during uncertain times. Having insurance on your equity portfolio during uncertain times gives you peace of mind to buy stock when you usually may not have.

What happens if the stock increases in value?

The investor will be entitled to the upside in the underlying stock as well as the other benefits for owning the stock
mentioned above. The breakeven point would be worked out as follows:

Net purchase price + holding costs – any tax benefits you may be entitled too - dividends and franking credits received.

In other words, the strategy is beneficial in a falling or rising market. In a flat market investors also have the conference of the protection and can look to sell covered calls alongside the protective put to help reduce the cost of the protection further – please refer to the collar strategy guide for more information.

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