Holding on to a large stock position is like trying to sit on a huge, wild animal. Can you tame the beast? Given increasing stock volatility...
Holding on to a large stock position is like trying to sit on a huge, wild animal. Can you tame the beast?
Given increasing stock volatility — the total return for the Standard & Poor’s 500 Index fell almost 4 percent Jan. 3 through Friday after rising about 11 percent in 2004 — it’s unlikely you will be able to escape market gyrations. If used wisely, derivatives called options contracts can provide some protection.
Large positions in your employer’s stock also leave you vulnerable to punishing market dips, particularly when you are nearing retirement.
Some 25 percent of employees older than 60 hold more than 50 percent of their 401(k) assets in company stock, so there are some dangerously overconcentrated retirement plans in place, even in this post-Enron age.
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“The number of investors who are beginning to realize that options are not a four-letter word is growing,” said Dave Beatson, a chartered financial analyst with Alexandria Financial Associates in Alexandria, Va.
“Those with concentrated stock positions — holdings of more than 10 percent in any one portfolio — may consider options as ways of protecting against large price declines, also known as hedging,” Beatson suggested.
Options are clearly not for everybody, and it’s essential to understand their mechanics and risks before using them.
As a derivative, an options contract represents a right to buy or sell an underlying stock or stock index at a certain quantity and price by a specific date.
A call option, for example, is a contract to buy 100 shares of stock at a “strike” price within a given period of time. The price of the call is called a premium.
The twin of the call is a “put.” This contract provides the right to sell a certain amount of a security at a future date and given price. Generally, puts can be used to protect or hedge against a price decline.
Calls, which can be “covered” by owning the underlying stock, can also provide income when a security or index rises in price.
Protecting your position
“Keep in mind that covered-call writing is perhaps the most conservative strategy, even permitted in IRA accounts,” said Beatson, although he said you may need permission “from your company’s legal staff and consult your tax consultant” when doing it with company stock. Many firms may not permit use of options to hedge their stock.
David Kalt, chief executive of optionsXpress Holdings, an online options brokerage, said 20 to 30 percent of his customers use options strategies to lower overall equity risk in their portfolios.
“They may invest 15 percent of their portfolios in options to replicate stock positions,” said Kalt of his customers. “That way they get upside exposure [for potential profit], but they’re not putting as much capital at risk.”
If you have a large position in your company’s stock, it exposes you to market risk, no matter how sound you consider your company. You may also be an executive and unable to sell the stock. Any stock holding that comprises a large portion of your portfolio is worth protecting with a hedging strategy if you want to reduce risk and can successfully work with options.
Put and call options
Mark Holoman, a bank analyst, wanted to ensure that he didn’t lose money on his investment in XM Satellite Radio Holdings, which he bought at $10.50 a share. So he bought 18 put options at $20. He eventually sold at $25 for an 80 percent gain. “A lot of people are afraid of options, but it’s not difficult,” Holoman said.
To hedge against a decline, you may buy a put option in addition to a call, so that if your stock tumbles to the strike price on the put, you make enough money to offset the loss in the actual stock. This is called a “collar.”
You can hold onto a large stock position and buy a call, provided that there is an exchange-listed option that covers your stock.
Selling your position
If you don’t feel comfortable with options, there’s a simple way to pare large stock positions. “Sell the stock, period,” said Larry Swedroe, research director for Buckingham Asset Management in St. Louis.
Swedroe said he may use options only to protect a stock with puts or until it qualifies for long-term capital gains, meaning you have held it for at least a year.
“The capital-gains tax rate (at 15 percent for most taxpayers) is the lowest it has ever been. Remember that the only thing worse than having to pay a tax is not having to pay it. Just ask employees of Enron, MCI, Intel, Cisco, Microsoft, Merck, etc. — all great or once-great companies.”
If you take the options route, make sure you fully understand how they work before you buy them.
You can lose money if your stock’s price doesn’t hit either strike price (on the upside or downside). The option can expire worthless and you lose the premium you paid on the contract. With calls, the stock also can be “called away,” which means the contract can force you to relinquish the stock.
Fees and commissions
Options also are difficult to use for long-term portfolio protection over several decades, and they get extremely complicated when you consider the myriad pricing and trading strategies, especially if you are speculating.
You also will pay commissions on each transaction and fees to open and maintain brokerage accounts. Some brokerage houses will require you to open and fund a margin account for trading options.
Educate yourself and run some virtual trades before you risk your money. If you don’t have the time to do the research, work with a fee-only financial planner, certified public accountant or tax planner who knows options. More information is available at the Chicago Board Options Exchange at www.cboe.com.
Ultimately, your main concern is looking at how much risk you are taking with single stock positions. If you are taking too much risk, don’t try to grab a tiger by the tail. Consider all forms of portfolio protection.