In my last post about averaging down without risk, I showed you a basic method of using derivatives to average down an adjusted cost base during a short-term price drop in a stock that is already in your portfolio. However, this strategy required that you put some cash on the line for your exposure. Today, I’m going to show you how to setup the exact same position in a way that involves a negative risk to cash flow, and still exposes you to the upside associated to your stock. This position will actually pay you an immediate lump-sum of money to take on a position that you think will go up in value.
A word of warning though, if you’re not up to speed on the basics of options, take a minute to flip through the tutorial and glossary on options, calls, and puts, so that you can get the most out of the pro-tips I’m about to share.
Quick review: a put is the opposite of a call. The buyer of a put contract owns the right to sell a stock at a given price, in exchange for a given premium. If you sell a put, someone is paying you for the right to sell you a stock at a given price. As an investor, if we are selling a put contract, we are hedging the price which we will pay to purchase a stock over a period of time. This effectively negates any short-term volatility associated with the stock, because we’d never engage in a transaction like this if we weren’t already comfortable with the purchase price associated with the underlying asset (unless we were a speculator….which we’re not, because speculating is childish and risky).
The reason why we must be comfortable with the underlying purchase price when selling a put is because, at any time throughout the duration of the contract, the purchaser can force the seller to purchase the asset at the strike price. All the money and obligations revolving around this position being a bit confusing,let me clarify how our investor from the previous posting would use this position to their advantage.
As mentioned before, our investor owns XYZ at $10 a share, and it has recently dropped to $5 a share due to short-term political uncertainty. The investor’s advisor is confident that XYZ will reach $15 a share in 12 months though. Unfortunately, our investor doesn’t have access to the hundreds or thousands of dollars required to average down their position by a significant amount, even though the tax benefits associated with such a manoeuvre are extremely favourable. Instead of purchasing a call option on the asset, which still requires that the investor pay for their exposure, the investor instead chooses to sell a put 12 month put contract at $5 (based entirely on the counselling of their advisor of course).
In doing so, the investor receives about $3 per share in premium from the buyer of the contractor. After this transaction, if XYZ should rise in price, the buyer of the put will have no reason to execute the contract (which forces the investor to pay out $5/share for the stock). The end result is that the investor has made a fixed profit of $3/share from the contract, due to the temporary drop in the price.
However, it is important to note that the investor should have kept $5/share in their bank account specifically put aside to cover the price of the contract in the event of execution. In doing so, the investor is keeping control of their capital, which is generating interest from the savings account, while still protecting themselves against the risks of the contract. This means that the investor doesn’t need to average down on XYZ stock until it drops as low as $2 a share (on paper at least), and can maintain control of their money of a longer period of time.
Looking at this situation as the investor, it becomes apparent that this is an extremely favourable situation. The investor receives cash right away (which is my favourite kind of return), and maintains a fixed upside exposure to a position they feel confident in. In the event that the stock should continue to decline, the investor is still able to take advantage of the buying opportunity at a lower price, even though they are even closer to the date at which the stock is expect to greatly appreciate.
The main risks of the position are therefore associated with time, as opposed to money. Since, as a generally rule, a personal investor has less money than say an investment bank, they are better able to bear the mid-term time-value risk, because they have a relative advantage in that respect.
Exciting right? It gets even better. In the next article, I’m going to flip both of these strategies on their heads, and demonstrate how the positions can be reversed to generate additional cash flows from an existing position that appears to be ‘dead money’ for the foreseeable future.
