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The right option for protection

Created:

23 June 2008

Written by:

Simon Thompson

Over a century ago, Anglo-American novelist Phyllis Bottomme wrote: "There are two ways of meeting difficulties: you either alter the difficulties, or you alter yourself to meet them." If that quote rings a bell, that's because I started this column in exactly the same way five years ago, in an article 'Playing Footsie with short-sellers' at the end of the 2000-2003 bear market.

It has great relevance today too, because we find ourselves at a similar juncture of the 2007/8 bear market which could quite conceivably reach a significant bottom in the coming months before embarking on a V-shaped autumn rally. At least, that's the theory that I have based my trading strategies on for the second half of the year. It also ties in with my Presidential Cycle Theory (see Presidential Profits, 27 May 2008) and the end of monetary easing by the Federal Reserve (Easing into Profits, 2 June 2008).

However, let's not get too ahead of ourselves just yet because there is some unfinished business with this bear market. To recap, two months ago (Histrionics, 11 April 2008) I noted that since The Great Depression, share prices in every single bear market have dropped by at least 25 per cent from peak-to-trough following a bull market lasting at least 30 months. That's a concern, because the 2003-2007 bull market ran for 51 months. I also observed that no bear market has been shallow if prices had doubled in the previous bull market. The record is fairly straight forward on this: there have only been eight bull markets since 1945 when shares rose by over 100 per cent. The last bull market was the ninth occasion this has happened. Worryingly, in every one of the subsequent eight bear markets, prices fell by at least 25 per cent.

So if history is about to repeat itself then the bare minimum we can expect from this bear market is a 25 per cent fall in the FTSE 100 from its autumn high of 6751. That would take it to 5063. This potential for a savage derating is not without reason either, if my earnings recession theory plays out (Earnings Recession looms, 20 June 2008) which is why I recommended keeping all our short index positions open (Simon's Top Shorts, 16 June 2008). Hedging portfolios by shorting the market aside, there is another way we can protect our shareholdings: use market volatility to our advantage.

How to protect yourself

The sharp rise in volatility may be stomach-wrenching if you are on the wrong side of a trade, but it is actually good news if you are holding stock and want to protect yourself from further downside risk. For instance, let's assume you are holding 1000 shares in mining giant BHP Billiton. These are trading at 1900p, having fallen from an all-time high of 2200p. True, you are probably regretting not banking profits at that record high. It's cost you £3000 in lost profit. But let's not dwell on the past, as that was an opportunity missed. Of more concern is the potential for a further drop in BHP's share price if equity markets take a nasty turn for the worse. Rest assured you are not going to be feeling smart if Billiton's price drops another 300p. Fortunately, you can protect yourself from this eventuality and may even be able to get out of the trade at that record high by using options.

Take for example the put and call options in BHP that are exercisable at 1900p on 19 December this year. They have no intrinsic value at all, only time value as the market price is trading in line with the exercise price. However, despite having just six months to expiry, the put options will cost you a hefty 300p a share, a total of £3000, if you want to protect your holding in this way. The call options are similarly priced at 300p each. Clearly, it is expensive to splash out £3000 on the puts as that equates to15.7 per cent of the current share price. And equally, selling your holding of 1000 shares now at 1900p each and reinvesting £3000 of the proceeds buying 1000 of the December call options at 300p each is hardly a smart move either. It may reduce risk to your capital, but you would need BHP's share price to be above a record high at expiry just to recoup the call option premium.

The smart option

The third option is the smart option. Namely, write December 2008 call options on your holding of 1000 shares, for which a buyer will pay you £3000. If BHP's shares are below 1900p in mid-December, the options will expire worthless and will not be exercised. In that event the £3000 call option premium received has helped protect your shareholding from the downside. Alternatively, if BHP Billiton's shares are above 1900p at expiry, the holder of the calls will exercise them and you will have to deliver your holding to them. Remember though that BHP's shares would need to rise from 1900p to above 2200p at expiry for the holder to make a profit on these call options. Even if that happens, you will have in effect sold your holding at 2200p a share: a record high. Finally, if the shares are trading between 1900p and 2200p on expiry of the options in December, you will still be showing a profit on your holding while having significantly limited the downside risk of holding the shares through this market turbulence.

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