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In our last couple of newsletters I’ve been explaining how Exchange Traded Options work and I mentioned a strategy referred to as a ‘Straddle’ which your financial adviser can use as a way of greatly reducing risk when you are investing in blue chip shares.

 

So how does a ‘Straddle’ work?

Let’s say a client owns $10,000 worth of NAB shares which he paid, say, $20 per share for. That means he’s currently ‘in the money’ by $8.27 the difference between his buy price and the current price of NAB on the market. All well and good. But what if he is afraid the market might fall dramatically (a reasonable fear in the current market with the Dow plunging another 1.9% yesterday).

In this situation, the investor can decide to underpin his investment by buying a Put option at, say, $22 per share for each of the shares he owns. This gives him the guarantee he can sell his shares for $22 if the market were to go into a free fall and the value per share was to fall below $22.

 

However, he has just incurred a cost to purchase the Put. Let’s imagine the cost per share was $3 to buy the Puts. Therefore, to counter this expense, the investor could sell a Call option on his shares at, say, $36 per share. Let’s imagine he could get $3 for each of these Call options that he sells. In that case, he’s cash neutral as the cost of the Put has been offset by the price he got for the Calls (note that selling an option means you are obligated to honor the transaction – see to the right).

  • Buying a Call – You have the right to buy a stock at a predetermined price.
  • Selling a Call – You have an obligation to deliver the stock at a predetermined price to the option buyer.
  • Buying a Put – You have the right to sell a stock at a predetermined price.
  • Selling a Put – You have an obligation to buy the stock at a predetermined price if the buyer of the Put option wants to sell it to you.

Admittedly, he’d have to sell his shares to the counter-party on the Call side if the price rises above $36. However, he might say he’s happy to take that profit on the stock for the peace of mind of knowing that he has a guaranteed sale price locked in with his Put i.e. $22 and his capital is secure.

This is called a ‘Straddle’ – a simple method of ensuring you won’t take a bath on your shares if the market plummets with the cost of buying the guarantee offset by the sale of Call on the other side. Importantly, Puts and Calls are also available on Exchange Traded Funds (ETFs) and Index Funds (each buying a share in an aggregated group of shares such as the ASX 200).

Having said that, a Straddle might also involve buying or selling both the Put and the Call as a linked transaction. These strategies can be quite lucrative in a market that is volatile and moving rapidly.

Whilst not many people would go for this option (it’s just too hard to get their minds around it) and it is not that easy to find an Aussie Stockbroker who will advise and act for you to implement the strategies, I always found it a good thing to talk about with some clients when I was a Stockbroker. As with so many things, it’s horses for courses and what’s good for one person is not good for another.

For more on ETOs.Β For more on straddles.Β For more on selling Puts and Calls.

Obviously we can’t provide advice on any specific strategy as that requires a specific license and you’ll need your financial adviser or Stockbroker to recommend a specific strategy providing he or she is convinced it’s in your best interests to do so.

As usual, you can’t access these kinds of strategies if you are simply in an industry fund or retail fund as you require access to a more flexible structure such as an SMSF. Again, your financial adviser can show you what kind of structure you’d need to pursue these strategies.

PS: Note that counterparty risk (the risk that the other side will not honor their side of the bargain) is basically covered by the ASX [for a fee] but it’s important to understand how/what is involved and understand what risk exposures are involved in each case.

Written by David Heycock