I attended a gathering early this week with a group of friends and one of them shared with me his experience on value investing, and this prompted me to write this article to share my view on this subject given the current market conditions.
If you are not familiar with value investing, it is an investing approach originally developed by Benjamin Graham in the early 1930s. Value investing became popular subsequently 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 that fits all the criteria for value investing, he will buy and hold the stock until the price reaches the stock’s intrinsic value.
Notwithstanding the above, I have to say that value investing is not as easy as before because the US stock market has become more volatile since 2010. In my opinion, the conventional “buy and hold” approach in value investing has to be modified to take into account of such volatile market conditions. In this article, I am going to consider how an investor can incorporate low risk options strategies into his existing stock position with a view to mitigating his investment risk.
As you can imagine, the objective of an investor owning a stock is to make money and this is when the stock 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 reward to the upside but a substantial risk to the downside.
Let’s say XYZ (a hypothetical company) is currently $600 per share and Tom has bought 100 shares. His total cost of investment will be $60,000, and this is his maximum risk in this position. If XYZ goes down to $500 per share, Tom will lose $100 per share or $10,000 in total. If XYZ goes to $0, Tom will lose the entire amount of $60,000. I must say that the risk exposure is huge and Tom should do something to mitigate it.
Here is the good news. If XYZ offers options, Tom will be able to use options to hedge the potential downside risk. More specifically, Tom can buy a put option that gives him the right to sell the stocks at a specific price on or before the expiration date. Suppose Tom decides to buy a put option with the strike price of $570 for a premium of $5.00. The risk / reward profile of his stock position will be modified as follows:
- If XYZ goes to $700, he will make a profit of $100 per share or $10,000 in total. The value of the put option will likely be worthless. However, the put option here is an insurance policy and is meant to protect the downside risk of the position. Thus, it is fine to lose the premium paid for the put option.
- The put option will be more relevant when XYZ goes down. 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 stock price is now $500. As a result, Tom’s net loss in this position is limited to $30 per share or $3,000 in total, plus the premium of $5.00 he paid for this put option. His total loss is restricted to $3,500 only.
Can you see how put options works in this case to help Tom to reduce the downside risk of his stock position? The interesting thing is that no matter how low the stock price goes, Tom’s total loss will be capped at $3,500.
If you are an investor, do you see how options can work for you to lower the risk exposure of your investment. I hope you do and get yourself educated on how to use options safely as a hedging instrument.
I will discuss some more examples of low risk options strategies in the next part, part 2.