Protecting Your Profits with Options; Part III

When markets are jittery, there is always reluctance among investors to allocate too much capital to stocks because of the downside risk, especially investors who are more conservative.

 For the more risk-adverse investors who may want both the security of T-Bills and the upside potential of stocks, there is an attractive risk-adjusted options strategy that is straightforward.

 Aptly known as the “Long Call-Long T-Bill” strategy, it’s an attractive and conservative hedging strategy that entails the creation of a synthetic convertible debenture.

 Through this bullish strategy, as an investor, you could partake in the upside potential of stocks through the buying of call options in conjunction with the purchase of very low risk T-Bills. In this way, the risk of holding the call option is offset by the interest received from the T-Bill.

 Investors at all familiar with convertible debentures will understand the rationale behind this strategy. A convertible debenture is a fixed-income security that incorporates a conversion feature, which offers the holder the opportunity to convert the ebenture to the company’s common shares if the price of the stock should rise past the conversion price. Under this scenario, the investor receives interest income along with the associated upside potential of the stock. If the price of the stock remains under the conversion price, the investor would simply not exercise the conversion option, but would still receive the interest payments.

 As is evident, the Call Option-T-Bill combination is akin to a convertible debenture but offers more choices as far as the selection of companies. Because convertible debentures are issued by the company, the selection tends to be limited. But with a synthetic convertible debenture, the choice of company is only restricted by whether there are call options available for the stock.

 For the investor, this translates into the ability to create a synthetic version of a convertible stock in the case when a convertible debenture is not issued for a certain company. Moreover, this strategy enables the investor to create a low-risk convertible debenture because of the very little risk characteristic of the T-Bill. The only risk in the strategy is the cost of the call options.

 Another point to keep in mind is that convertible debentures issued by companies are subject to credit risk while this synthetic version is not.

 You may be questioning the low percentage return of this strategy, but, considering the minimal risk, it’s very good and better than what you would have earned via a straight T-Bill purchase.

 The fact is that a Long Call-Long T-Bill strategy is a conservative trade geared for the conservative investors and is akin to that of buying a convertible debenture.

 The maximum risk of the strategy is the cost of the call options and you won’t lose more should the stock plummet.