A Call for Added Protection

During the last two weeks, I have been writing about how one can protect gains earned. In both strategies I have discussed, we use put options as a form of financial insurance to cap our exposure to the downside. The problems with puts, you'll recall, is how expensive they are. In last week's column, we partially solved the problem of expensive put insurance by using a strategy called a collar. Unfortunately, even though collars make put protection less expensive, you will also recall that they limit one's upside.

In this week's column, I will discuss another way to protect your winnings, which overcomes many of the weaknesses of using protective puts and collars. As opposed to the previous strategies we mentioned, which overlaid stocks with protective put options, this strategy uses call options alone.

Those of you who have experience in options may raise an eyebrow at this--"How can one protect one's downside with a call option?! A call option gives an investor access to the upside of a stock, after all!" 

While it might seem counterintuitive at first, it all becomes very clear when you see it in pictures.

Downside Protection Illustrated
In past issues, we introduced the way we like to look at option strategies at Morningstar through something called probability diagrams. To illustrate the concepts of a probability diagram, let me show you what an ownership position in a stock would look like.

Figure 1

The price at which you buy the stock ($5) is the vertical line dividing the green section from the red. If the stock falls from that point, you are in the red--losing money, in other words. If the stock rises from that point, you are in the green--making money. Buying a stock, one can only lose 100% of one's investment, so the diagram cuts off at the zero mark. In contrast, there is no upside cutoff for a stock, which is why the green "tail" is extended on far past the $10 mark. Stocks more often go up than go down, which is why there is a greater amount of area shaded in green than red. The height of the curve directly relates to the probability that it will jump to that price; it's highest at the present stock price because the most likely place for a stock to jump is just around the present price.

Now that you know what a stock looks like in a probability diagram, let's take a look at how call and put options would be represented, excluding the cost of the options. First, is an at-the-money call option.

Figure 2

A call option simply grants an investor the right to profit if the underlying stock rises. In the above diagram, we see that indeed. If the stock rises above the market price, we start to profit from the investment because we start moving into the green section. Now, let's take a look at a put option struck at-the-money.

Figure 3

  - source: Morningstar Analysts

A put option grants an investor the right to profit if the underlying stock falls, and here in this diagram, we see just that. If we buy an at-the-money put option and the underlying stock falls from $5 to $4, we are in the green--by $1.

Now that you understand the intuition behind the probability diagrams, let's see what a protective put option overlaying a stock looks like.

Figure 4: Protective Put Overlay

  - source: Morningstar Analysts

Here we've got our stock in the top third of the diagram, and we add a put in the middle third. Our potential loss from the falling stock (the red part of the top diagram) is neutralized by our potential gain from the protective put (the green part of the middle diagram); this is represented in the resulting diagram as gray. Note, we have no economic exposure to the downside because the profit from our put will exactly offset the loss from our stock.

Now, I'd like you to compare the resultant diagram in Figure 4 with the diagram of a call option in Figure 2. Do you notice that the naked call option gives us exactly the same economic exposure as a stock overlaid by a protective put? Looking at the position this way, it is obvious that buying a call is the same thing as overlaying a stock with a protective put!

Protecting With Call Options
The big difference between using calls as protection and the other forms of protection we have mentioned is that the call strategy is not an overlay. In other words, the call strategy means we are owners only of an option and not of an option which modifies the risk/return characteristic of an underlying stock. The implication of this is that if you want to use this call protection strategy to hedge a stock you already own, you would have to sell the stock and use the proceeds to buy the option in the stock's place.

Selling a stock has tax implications, so you will have to consider these before embarking on such a strategy. However, for investors using this strategy in a tax-exempt account, you obviously will not have a taxable event resulting from the stock sale.

What to Keep in Mind
The owner of a call option does not have the right to receive company dividends. In return, the option premium a call buyer pays is lower by the amount of the dividend expected over the life of the option. Economically, it should work out as a wash--either you receive your dividends up front in the form of a discount on your call option or you hold the stock and receive your dividends during the next few quarters. But investors who factor periodic dividend payments into their daily expenses should take note.

Additionally, for call protection, we suggest buying an in-the-money call (that is, one whose strike price is below the present market price of the stock). The price of ITM calls is mainly intrinsic value with only a small amount of time value.

A version of this article originally appeared in the June edition of Morningstar StockInvestor newsletter.

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