Protecting for the Downside

stargazer · 10 February 2008

Hi all

Reading a book on investing at the moment and talks about real estate and shares etc.

It indicates that when you buy real estate you protect yourself with insurance should things go wrong in the investment, be it Building insurance and Landlord insurance etc.

Then it goes on to say to protect yourself when you have shares in stocks incase the market goes down. It doesn't go into specifics but mentions using options.

Asking if one of the learnered forumites could expalin how you do this.

Cheers
SG

GreatPig · 10 February 2008

Google "hedging" for finance and you'll find lots of info.

With options you could purchase puts in the same stock which will increase in value if the share price falls. Due to the nature of option pricing, if the share price moves significantly in either direction you'll make money, but if it doesn't move much you'll lose overall due to the premium you paid for the options (like you effectively lose the insurance premium on a house).

I'm sure there are plenty of other ways to hedge a portfolio as well, but that's one example.

Cheers,
GP

RichKid · 10 February 2008

GreatPig said:
Google "hedging" for finance and you'll find lots of info.

With options you could purchase puts in the same stock which will increase in value if the share price falls. Due to the nature of option pricing, if the share price moves significantly in either direction you'll make money, but if it doesn't move much you'll lose overall due to the premium you paid for the options (like you effectively lose the insurance premium on a house).

I'm sure there are plenty of other ways to hedge a portfolio as well, but that's one example.

Cheers,
GP

Following on from GP's post you could try the Derivatives forum here on ASF for coverage of the topic as well.

stargazer · 10 February 2008

Hi....

Great Pig

With options you could purchase puts in the same stock which will increase in value if the share price falls.

Click to expand...

Say I own 10,000 shares in mmm say Oxiana at say $3.50 so you leave this open wanting the price to go up.

Say it drops to $3.20 how do you set it up, how does it increase in value if the price goes down.

Just need an example or a Link.

Cheers
SG

Trembling Hand · 10 February 2008

stargazer said:
Say it drops to $3.20 how do you set it up, how does it increase in value if the price goes down.

Just need an example or a Link.

Cheers
SG

Very simple example here (maybe to simple)
http://www.investopedia.com/terms/m/marriedput.asp

Just a note you have not stumbled across a fail save way of protecting you investment. The cost of buying option protection is very high and for only a limited time frame. You will find that the cost of the options will take away a lot of profit if not done properly.

Remember as a share owner you get paid for the risk. If you pass on the risk to someone else, the option writer, they are now going to want to be paid for taking that risk. And they normally do get the $$.

stargazer · 11 February 2008

Thankyou very much Trembling hand. Nothing is easy..lol

A stop loss would do similar to protect your capital.

Cheers
SG

bloggs_oz · 11 February 2008

stargazer said:
Hi....
Say i own 10,000 shares in mmm say Oxiana at say $3.50 so you leave this open wanting the price to go up.

Say it drops to $3.20 how do you set it up, how does it increase in value if the price goes down.

Another possibility is to write (sell) a covered call option. This way you'll get some downside protection, but will be required to sell your shares (or buy the options back) if the share prices is greater than the expercise price of the option at expirtaion date. More info at http://en.wikipedia.org/wiki/Covered_call

I generally write covered call options to generate some extra income, and trade/speculate in put options as well.

Nick Radge · 11 February 2008

Another possibility is to write (sell) a covered call option. This way you'll get some downside protection

Not quite true. You will only receive protection to the value of the short call, which usually is not much, just 1% to 2% tops. If the market falls further you continue to have exposure.

bloggs_oz · 11 February 2008

Nick Radge said:
Not quite true. You will only receive protection to the value of the short call, which usually is not much, just 1% to 2% tops. If the market falls further you continue to have exposure.

I did say _some_ downside protection. It's my preference in the current market to write covered calls over buying put options, as you benefit from the high volatility that's in the market at the moment by getting a premium for your call options (as opposed to paying a premium for the volatility). But in the event of a market crash you're obviously better off with a put option, which will put a limit on your losses.

I'd dispute that you get 1% to 2% for writing a call option. It is highly dependent on what options you sell. An example inline with the original question is to sell OXR1B (March $3.50 call) options; last traded at $0.18 (5.79% of current share price).

Is it the best choice for the original poster? I don't know; but it's another option available at least.

Protecting for the Downside

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