Executive Summary
The beginning investment portfolio was composed of ten Dow Jones Industrial 30 stocks that totaled an investment of $498,598. A hedging tactic was applied in order to have the capacity of liquidating the put options at prices that are close or in the money on the present Dow 30 portfolio. This tactic is applied in order to reduce the potential of risk in the event that the market goes flat or in the declining direction during the next year and a half. The selling of the put requests against the value of the beginning investment at strike values that are near or in the money will enable the investor to optimize on the time premium value of the investment. The comprehensive returns will have a market cap on the upward price movements.
Any of the losses in that are taken in the portfolio during the next year and a half will be calibrated by the put option premium. The option premiums that were collected were $63, 355. The complete returns on the net investment in the stock portfolio were: 13.62% in the event of the market rising, 13.53% considering a flat market scenario, 6.63% in the consideration of the market declining with a 10% average and – 2.08% on a market that declines with a 20% average during the next year and a half time. The addition of receiving fixed incomes in the portfolio decreases the comprehensive portfolio risk. The decreasing of the risk is achieved by making investments in secure US Treasuries and low volatility money market securities.
The beginning investment portfolio is composed of congruent investment amount that are distributed in ten DOW 30 stocks. These stocks include: American Express ( AXP), Cisco system (CISC), Walt Disney ( DIS), , EI du Pont de Nemours & Company ( DD(, Goldman Sachs, Group, Inc.( GS) ,Home Depot (HD), Intel Corp. ( INTC), Johnson and Johnson ( JNJ), JP Morgan Chase and Company ( JPM) and Wal-Mart ( WMT). The complete stock investment portfolio is allocated as demonstrated in eh following table;
Hedging Approach
The recommended strategy for providing hedging protection of the present portfolio is to sell the calls at primarily a value that is in the money. This approach will be applied in order to enable the investor to realize as much of the premium that is feasible. The objective of the investor is to maintain a bullish perspective while proving protection with regards to the short term downside risk during the next year and a half. This can be achieved by applying a number of strategies. The precise perspective of the investor has not been clarified due to some of the conflicting statements.
The investor perceives that the market will most probably stay flat with some possibility of downside movement. Notwithstanding, the investors objective of realizing profits in the near term and applying avoidance with respect to any of the decreasing trends in the market , infers that the investor is expecting the market to move in a negative direction, that has the possibility of being more than mild movements. In the event that the investor demonstrated concern for the avoidance of any of the negative spikes that may occur, Imply that he may anticipate a negative motion in the market. In the event that the investor was worried with regards to a substantial downside movement in the market and wanted to secure the investment, the best hedging tactic would be to procure a put option in the event that there should be a market movement in the downside direction. The put would provide the protection with regards to any downside movement that goes under the strike price. The expense of the put option could be covered and supplementary income would be realized by selling the calls foe equivalent share prices.
The stock prices for these protective options would be required to approximate the strike price in order to apply the put. In selling the calls for an amount that is near or at the money, the puts would be more significant and compensate for the expense. The expense would be marginally out of the money. The price spread that is present between the two options at distinct strike prices would assure that the requisites of revenue generation are being fulfilled.
Notwithstanding, in the event that the investor maintains the perspective that the market will maintain a flat quality within certain downside risk, then procuring calls against the values of the stock in the investment portfolio would be the most prudent. This tactic enables the investor to gain with the accrual of option premium in the near term. This strategy is not foolproof, it does not provide protection against the insolvency of an organization. These options provide a restricted amount of protection with regards to the downward movement of prices by efficiently decreasing the investor’s expense to of breaking even with the stock.
On the other hand, the marketing of the calls provide limitation with regards to any upwards movements in price by creating a cap where the investor would have the capacity of realizing any returns derived from the upward price movements. The investor would wish to market the calls that are at a level that are near of under the money. This would be attributed to the premise that these calls possess the greatest time premium.
In the review at the initial stock in the portfolio, 3M (MMM) the investor would be the proprietor of 300 shares that are priced at $157.12 that would represent a stock investment of $467, 136.00. The investor could subsequently market the one hundred call contracts at the $155.00 strike price for $7.12 each or a total investment of $7,120.00. The call option is positions approximately near the money. The investor could have his stock received at the price of $155 or higher in January 2015. Nevertheless, the marketing of the call options against the stock investment decreases the investment bases to approximately $40,240 or $131.40 per share.
The diminished cost basis that the received option premium would supply the investor with a comfort zone with regards to any temporary decrease in the value of the stock or in the event of any prolonged sideward movements. The options would deter the investor from realizing any profits that are above $131.40 on the actual stock. The option premium revenue and dividend income would be the only profits that can be realized by the investor over the next year and a half.
The investor does not receive protection from unlimited downward motions of the price and the hazards continue to stay with any downward movements in price. The hazards of loss are mitigated by the marketing of the call option. The marketing of the call causes the investor’s point of breaking even to $130.20 that are inclusive of the anticipated dividends that are not assessed on the basis of their present value. In the event that the stock should close below $130.20, the investor would realize losses. On the contrary, the investor would experience a loss of the stock and would be called in the case that the stock remains at $157.12 or experiences upward price movement. In the marketing of the calls at a strike value that is approximately in the money, the investor does have the potential liability of having the call options placed into effect and having a call placed on the stock.
HEDGING APPROACH – PERILS/BENEFITS
As it is demonstrated with MMM, the optimal return in a market that is flat or rising would be $5,721 for a complete return of 13.44% or 12.03% on a yearly basis. In the circumstance that the stock were to decrease by 10%, the returns would total to be 9.77% or 6.55% annualized. This assertive return in the event of a downward motion in the price of the stock is primarily attributed to the vended call premium that was realized. In the case that the stock’s value were to decrease by 20%, the return would be a negative 2.23%. There would be a continuation of the losses in the event that the stock price were to move in a downward direction. It can be observed in the negative 20% stock situation that any of the losses would be compensated by the vended option premium. The net result is that the perils continue to manifest themselves. The perils are mitigated by the vended option premium while the upper value of the stock is capped. This circumstance would be sustained throughout the duration of the option.
In the application of this perspective in the entire stock portfolio, an n identical outcome can be observed from each of the securities in the stock portfolio that is composed of ten DOW 30 stocks. The returns have a cap on the upward price movement. The perils have been substantially mitigated with regards to the downward price motions in a 10% and 20% quality of market price motion.
FIXED INCOME INVESTMENT
The investing in the US Treasuries in addition to a money market fund provides the investor with minimum potential for return without any peril. The returns on US treasuries investments have an average yield to maturity of 1.64 %. The funds that are placed in a money market will provide less handsome returns with a limited amount of risk. The peril is restricted to the quality of liquidity due to the credit being equivalent to zero. Inflation is another potential peril due to the attribute that the 1.64% annual return may not compensate for inflation. There is a peril of temporary price, in the event that there is improvement in the interest rates due to the price of the bonds becoming modified on an interim basis. The 1.64% return is assured if the securities are maintained until their maturity, irrespective of any near term modifications in the price of the bond that can be attributed to the interest rates. In conclusion, the combination of the peril free fixed income securities with the stock portfolio is another approach to minimizing the risk that the investor is exposed.
CONCLUSION
The portfolio of the investor should be hedged by vending the call options in correspondence to the proprietary shares. The vending of calls that are slightly or in the money will create the most substantial amount of time value premium and provide the most comfortable margin for the investor over the next year and a half. There will be a capping of the returns with upwards price motions, however, the losses will be restricted on the downside price motions. Aggregating the fixed income elements to the portfolio permits diversification and a decrease of the comprehensive risk.
