I attended a meeting earlier this week with a group of friends and one of them shared his experience in value investing with me, which prompted me to write this article to share my view on this subject given the current market conditions. .
If you are unfamiliar with value investing, it is an investment approach originally developed by Benjamin Graham in the early 1930s. Value investing later became popular when Warren Buffett took this concept to the next level by focusing on finding companies with economic moats at a bargain price. What happens is that once an investor has identified a candidate who meets all the criteria for value investing, he will buy and hold the stock until the price reaches the intrinsic value of the stock.
Notwithstanding the above, I have to say that value investing is not as easy as it used to be because the US stock market has become more volatile since 2010. In my opinion, the conventional “buy and hold” approach in value investing must be modified to account for these volatile market conditions. In this article, I will consider how an investor can incorporate low-risk option strategies into their existing stock position in order to mitigate their investment risk.
As you can imagine, the goal of an investor who owns a stock is to make money and that is when the share price goes up. On the other hand, if the stock price goes down, he will lose money. From a risk and reward perspective, a long stock position has unlimited upside reward but substantial downside risk.
Let’s say XYZ (a hypothetical company) is currently at $600 a share and Tom has bought 100 shares. His total investment cost will be $60,000, and this is his maximum risk in this position. If XYZ falls to $500 per share, Tom will lose $100 per share, or $10,000 in total. If XYZ reaches $0, Tom will lose the full amount of $60,000. I have to say that the risk exposure is huge and Tom should do something to mitigate it.
Here’s the good news. If XYZ offers options, Tom may use options to hedge potential downside risk. More specifically, Tom can buy a put option that entitles him to sell the stock at a specified price on or before the expiration date. Suppose Tom decides to buy a put option with a strike price of $570 for a premium of $5.00. The risk/reward profile of your stock position will change as follows:
- If XYZ reaches $700, you will earn a profit of $100 per share, or $10,000 in total. The value of the put option will probably be worthless. However, the put option here is an insurance policy and is intended to protect the downside risk of the position. Therefore, it is okay to lose the premium paid for the put option.
- The put option will be more relevant when XYZ falls. Suppose the stock is now $500. Tom will lose $100 per share, or $10,000 in total. However, the put option will be worth at least $70 per share because it gives Tom the right to sell XYZ at $570 even though the share price is now $500. As a result, Tom’s net loss on this position is capped at $30 per share or $3,000 in total, plus the $5.00 premium he paid for this put. The total loss from him is restricted to $3,500 only.
Can you see how put options work in this case to help Tom reduce the downside risk of his stock position? The interesting thing is that no matter how low the stock price is, Tom’s total loss will be limited to $3,500.
If you are an investor, do you see how options can work for you to reduce your investment risk exposure? I hope you do and educate yourself on how to safely use options as a hedging instrument.
I will discuss some more examples of low risk option strategies in the next part, part 2.
