A call option with a cash twist

PORTFOLIO POINT: Setting aside a percentage of cash to buy shares when the market falls is a call option that every investor can use to their advantage.

Being a sharemarket investor is far from the most enjoyable game in town at the moment.

Shares are still down by around one-third from their 2007 peak. After they recovered to a market level of beyond 5000 points, they fell back below 3000 points. The 50% fall of the market from the end of 2007 to early 2009 is in line with the biggest falls in Australian history, alongside the 1987 market crash, the early 1970s and the Great Depression sharemarket fall in 1929.

More than that, we hear stories about the possible impact of “high-frequency traders”, speculators who hold shares for tiny periods of time that are rumoured to have a disproportionate impact on market movements. Events like the “flash crash” on the US sharemarket make us wonder just what forces are at play.

The question then is, if this is the landscape sharemarket investors are faced with, how should they react?

I think the first step is to go back to fundamentals. As a sharemarket investor you are buying a part ownership of a company, or portfolio of companies. Indeed, if you invest in a well-diversified investment vehicle like an index fund, exchange-traded fund or large, traditional listed-investment company, you are investing in a slice of all the companies in an economy.

For most of us, what we are hoping to achieve is a steady increase in the earnings and dividends of the companies we own. In some analysis recently, it was interesting to note that even through the market volatility of the past five years, the top 10 companies had increased their dividends (Buffett’s dividend secret). If our focus is on dividends and company earnings, the threat of volatility is given some perspective.

Many of the great ‘value’ investors, including Warren Buffett, call on investors to not get overly concerned with sharemarket price movements. Indeed, one of his most famous pieces of advice is “to be fearful when others get greedy, and be greedy when others get fearful”. That is, to react opposite to market sentiment and falling market prices by buying aggressively – of course, this is harder to do in theory than in practice.

There is also a body of evidence – both from research and the wisdom of people working in investment markets – that sharemarkets tend to overreact. When times are good they go up too far. When times are bad, they fall too much.

So, what might investors do to adjust to fears over increased sharemarket volatility and the market’s tendency to overreact? Or, to take this a step further, is there a way that they can even profit from this situation.

My suggestion is to consider creating a special “call option” strategy. A call option gives the holder a right, but not an obligation, to buy an asset in the future. For example, you might buy a call option on Telstra shares at $4 for September 2013. That gives you the right to buy Telstra shares for $4. If, in September 2013, Telstra shares are trading at $5 you are likely to exercise your right to buy them for $4, because you can then sell them on the market for $5. If they are trading at $3.50 you won’t exercise your right to buy them for $4, because it is cheaper to buy them on the market.

The call option strategy I am suggesting is a little different to a pure option – it is to accumulate an amount of cash that is specifically set aside for investment opportunities if markets were to fall sharply. Specifically, this would involve setting aside 5%-10% of a portfolio in cash that can be used to take advantage of any opportunity that comes from sharemarket falls as a result of general overreaction or increased volatility due to forces like high-frequency trading. This cash holding effectively becomes a call option – giving the holder the right but not the obligation to buy shares in the future.

Let’s see how this might work with a $500,000 portfolio. If you were to put aside 7.5% of the portfolio value as a cash holding for future buying opportunities, this would amount to $37,500. Let’s say this portfolio is 60% in growth assets (shares and property assets) and 40% in defensive assets (cash and bonds), with an expected return of 10% from the growth assets and 5% from the defensive. The expected portfolio return is 8% a year.

If we adjust our portfolio and add a third investment class – a cash holding equal to 7.5% of the portfolio value for strategic sharemarket investments taken equally from the existing cash and sharemarket holdings – we end up with a new portfolio that has:

• 56.25% in growth assets;
• 36.25% in defensive assets; and
• 7.5% as a cash holding set aside as a “call option” on future strategic investments.

Interestingly, this portfolio has an expected return of 7.81% a year (based on growth assets having future earnings of 10% a year and defensive 5% a year), only slightly lower than the 8% a year return of the 60% growth, 40% defensive portfolio. But there is now a significantly improved ability to react to sharemarket downturns.

This strategy also buffers the portfolio a little more from any sharemarket downturn. If shares were to fall by 50% (roughly the level they fell during the GFC, 1987 crash, 1970s and Great Depression), the pure 60% growth portfolio would fall by 30%. The portfolio with the extra cash in a call option role would only fall by 28%.

The downside is that the 5%-10% call option strategy will limit portfolio growth during good times. This is not good. However, the benefit of greater access to cash levels to make purchases if markets fall sharply, whether it be due to overreaction to some bad news or to the influence of high-frequency traders, potentially lets an investor take advantage of a unique situation.

While post GFC returns have not yet created fortunes, investors with the courage to buy when markets were around 3000 points in early 2009 have seen capital growth of nearly 50% and three-and-a half years of impressive dividends. Looking back at the sharemarket returns of investors who bought shares at the bottom of the 1987 crash, during the worst of the 1970s and after the Great Depression downturn, we can see that they provided outstanding returns for courageous investors.

Conclusion

Options are widely used to manage risk in investment markets. Creating an effective call option – the right to purchase undervalued shares – by holding additional funds in cash is a strategy worth considering for investors with concerns about the potential for higher-than-average future returns.

The downside is that it slightly reduces portfolio returns during periods of good sharemarket performance. The upside is that it will reduce the amount portfolios fall in value, and provide investors with the funds and confidence to take advantage of any extreme falls in sharemarket values.