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Options for protection with BHP Billiton

Created:
18 August 2008
Written by:
Simon Thompson

The great thing about volatile equity markets is that option premiums rise to reflect the sharp share price movements we are now seeing daily. And, as I pointed out two months ago, we can use this to our advantage ('The right option for protection', 22 June 2008).

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To recap, at the time shares in BHP Billiton were trading at 1,900p, having fallen from an all-time high of 2,200p a month earlier. So to protect shareholders from suffering an even deeper fall, but keeping open the potential for the shares to recover, I recommended writing the December 2008 call options. The warrant premium at the time was 300p a share and the call options had an exercise price of 1,900p. The strategy was pretty straightforward.

If BHP's shares are below 1,900p in mid-December, the options will expire worthless and will not be exercised. In that event, the call option premium received has significantly reduced the downside of holding the shares. Alternatively, if BHP Billiton's shares are above 1,900p at expiry, the holder of the calls will exercise them, but the shares would need to rise to above 2,200p at expiry for the holder of the call option to make a profit. Even if that happens, shareholders writing the call options will have, in effect, sold their holding at 2,200p a share: a record high. Finally, if the shares are trading between 1,900p and 2,200p on expiry of the options in December, shareholders will be showing a profit on their investment while having limited the downside risk of holding the shares through this market turbulence. And without doubt the market has been turbulent since I outlined this trading strategy, with BHP Billiton's shares plunging 20 per cent from 1,900p to 1,523p.

No horrendous losses

However, shareholders who followed my advice and wrote the call options are, in effect, in the stock at 1,600p a share, so will not be suffering the horrendous losses of other investors. There is also a final dividend of 21.9p payable on 25 September, which reduces the break-even point even further. Moreover, with the shares falling so much, the December 1,900p call options are now only trading at 90p each, so can be bought back to neutralise the position. And this is the really smart part. We can fund the 90p cost of buying back those call options by writing another December 2008 call option on the shares at a lower exercise price, so it isn't even going to cost us any money. Moreover, this strategy reduces the carrying cost on the shareholding, reduces downside risk and offers upside potential if BHP Billiton's shares recover.

For instance, the December 2008 call options with an exercise price of 1,700p are trading at 145p, so shareholders can write these call options safe in the knowledge that the shares would have to rise from the current price of 1,525p to 1,845p for the buyers of the options to make any money. If that happens, this is great news for shareholders writing the options because they will have pocketed the 300p option premium on the December 1,900p calls, a further 145p on the December 1,700p calls, earned a final dividend of 21.9p a share less and paid out 90p a share buying back the original December 1,900p calls. This gives a break-even point on this position of 1,523p - exactly the current share price. In other words, even though the shares have fallen by 20 per cent in two months, shareholders adopting this traded options strategy will not have lost any money.

Clearly if the shares do manage to get above 1,700p by mid-December, the holder of the option will exercise them. Importantly, though, this would guarantee a 177p-a-share return to shareholders writing the 1,700p December 2008 call options in only four months. That equates to 11.5 per cent of the share price, or an impressive annualised return of 38 per cent.

Benefiting from upside

Alternatively let's assume that BHP Billiton's shares fail to make any headway between now and mid December. In which case, the holder of the December 1,700p calls will not exercise the options and they will expire worthless. So shareholders will still be in the stock for 1,523p at the end of December, but importantly will not have suffered the 20 per cent loss endured by other investors who did not adopt this protective traded options strategy back in June. And even if BHP Billiton's shares end up trading between 1,525p and 1,700p in mid-December, the call option holder will still not exercise, but shareholders will have benefited from any share price upside above 1,523p.

True, the shares could continue to fall and end up below the 1,525p break-even point by mid-December. However, if this happens, we can avoid suffering losses simply by buying back the 1,700p December call options (which will be trading at a price significantly less than the 145p the buyer of the call option has paid), to neutralise the position. Then, as before, we can raise the cash to fund this buy-back by writing more out-of-the-money call options - where the exercise price is above the share price. And because volatility is likely to be high if BHP Billiton's shares continue to fall, then warrant premiums will remain high, too, to reflect this.

Bear markets can be savage, but by writing call options in a smart way and using market volatility to our advantage, we can reduce the risk of playing the markets. There are not many trading strategies that allow investors to suffer a 20 per cent fall in the value of their shareholding and not lose money, but this is one.

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