“Rule No.1: Never lose money. Rule No.2: Never forget rule No.1." - Warren E. Buffett

Wednesday, November 26, 2008

A way to lock in minimum gains on your investments

This strategy can be used when you are sitting on huge unrealised profits on a stock and want to protect it.

For those who are wondering how to save the hard earned profits in this bearish volatile market here is a simple solutions to lock in minimum gains on your investments. This is a wonderful article by Srividhya Sivakumar, much impressed,and i thought i can give a chance for my readers also to enjoy, just sit in and give a read you will really appreciate the author,which gives a wonderful solution.

After all, it is not an easy task to just sit on the sideline and watch volatility wie away a good chunk of your hard earned profits. But worry not, for there is a way to seal minimum profits on your investments use the protective collar. This simple option strategy can lock in profits on your stock regardless of the constant meandering in the stock markets and that too at little cost. Read on......

Using Protective Collar:
Simple and easy to set, a protective collar strategy should be used when you are sitting on huge unrealised profits on a stock and want to protect it. It can be establised by purchasing a protective put(buying puts at lower strike price) and simultaneously writing a a convered call (selling calls at higher stike price) for the same month on the stock that you hold.

For instance, say you hold 175 shares of ICICI Bank bought at Rs.500. This means you would currently be sitting on an unrealised profit of Rs.200 on a pershare basis, if we take into consideration the stocks current market price of Rs.700. You can lock-in on minimum gains using a protective collar.

A protective collar on your ICICI shares can be set by selling higher price call options on the stock. Depending on what price you would be compfortable parting with your stock holding, you can decide on the strike price of the call option.

Let us say you sell one lot (175 shares) of ICICI september 740 call option trading at Rs.16.5

This means that if the stock price moves above Rs.740 during the period of the contract, you should be willing to sell the shares at the strike price, the second part of the strategy inovlves buying a protective ut on ICICI Bank. You can do this by buying puts at a strike price, which would seal the minimum profits you want to lock in for your share holding.

In this case, you can do so by buying ICICI sep 660 Put option trading at Rs.16.7. This will help you lock ina minimum gain of Rs.160 per share (Rs.660 - Rs 500)

But at what cost? In this example, while selling the 740 call will entail an initial credit of Rs.16.5 a share, the buying of puts will mean a debit of Rs.16.7 a share. So on a net basis, you have set a protective collar for juist 10 paise a share.

Note that different spreads can be chosen depending on your stock price outlook and risk tolerance. Further, in some cases the strategy can also be set at net intital credit.

Possible outcomes:
If ICICI stock price falls much below the strike price of the put option (Rs.660) gains from the long put position will offset the notional loss in the stock's value.However, the sold calls will expire worthless. This means you will get to pocket the premium that you received while writing the call (Rs.16.5). Alternatively if the stock price rises beyond the strike price of the call options (Rs.740) it will result in a loss.
However, this loss to an extent will be offset by the rise in value of your gains on ICICI shareholding. While the put opitoon will expire worthless, you willstnad the risk of exerciese at Rs.740, in which case you may have to part with your stocks. And if the stock price trades in a range between the put strike price of Rs.660 and the call strike price of Rs.740, both the options would expire worthless.
In this case, you lose nothing but the amount spent in setting the spread. But had you set the spread for strike prices that would have resulted in a net initial credit, you would get to pocket that for good.