SMSF Investment StrategiesSharing Simple Strategies for Self Managed Super Funds
Insuring your paper assets
Last week a storm damaged the fences on one of our investment properties. I check our insurance policy and was relieved to find out that storm damage was covered and the maximum cost of repair to me would be $300, which is the level of “excess” I chose when I bought the insurance. Almost everyone I know buys insurance for their physical assets like properties, cars and even home contents like furniture, tv, computers, jewelry, etc. Yet most stock investors I know do not buy any insurance for their stock portfolio even though this asset may be worth far more than their cars and tvs.
Do you need insurance for your paper assets like shares? Are there risks that can affect the value of your paper assets? Last year, a number of well known listed companies like Allco Finance and Timbercorp went bankrupt and their shares are now worth close to nothing. Others companies have suffered a major drops in their share prices when there was bad news that affected the whole market (like the global financial crisis) or bad news that affected a particular company (like a bad earnings report or difficulty in getting financing). I think most stock investors are not even aware that they can insure your shares, even though this insurance has been available through the ASX for the past 30 years and they are called put options.
Buying a put option is exactly like buying insurance. You can chose your level of protection and you pay a premium to the insurer to cover you for a period of time. For example, you own 1200 RIO shares which is currently trading at around $59 per share. You have read in the news that lately RIO is having problems with their largest customer, China and iron ore prices are likely to be lower in the next few months as it was recently announced that China has completed their stock piling of iron ore. RIO will be announcing earnings on Aug 20 and you are afraid there may be some negative news from management during the earnings announcement that could cause the share price to drop, but you don’t wish to sell your shares as you still think RIO is a good long term investment. What you can do to protect from any near term downside is to buy a put option. Put options are sold at different strike prices which matches the level of protection you wish to have. Perhaps you bought RIO at $40 and you are happy with a level of protection of $50 (i.e. have an excess of $9) and are willing to pay an insurance premium of $1 per share. Below are a few available “insurance policies” that you can purchase from the ASX:
For a $1 premium, you could get a protection level of $55.20 until 27 August 2009 (one week after earnings) or a protection level of $50.27 until 24 Sept 2009. If you choose to buy the Aug09 $55.20 put option and RIO falls to $50 before 27 Aug 2009, you can either:
- sell your RIO shares at the guaranteed price of $55.20 by exercising your put option or
- keep your shares and sell your put option which would be worth at least $5.20 (difference between strike price of $55.20 and share price of $50 and any remaining time premium). This $5.20 is the insurance payout will help to offset the loss of value in your share price.
If the price of RIO remains above $55.20 by 27 August 2009, your Aug09 $55.20 put option will expire worthless and you would lose the premium you paid for the insurance. The insurance may not be cheap (especially when there is a big perceived risk during the coverage period) but at least you have a means to manage your risk and not just hope and pray that the share price will not drop.
All companies in the ASX-20 have options so the above hedging strategy can be used if you own shares in those companies. Not all shares listed on the ASX have options so you cannot buy insurance for that specific company but you can buy put options for a similar company in the same sector if there is a risk you see that could affect the whole sector (e.g. if you have own resource company shares and you think commodity prices are coming down) or you can buy put options in a broad index like the ASX200, if you think there are risk affecting the whole market. Watch this video from the ASX about using this strategy to manage risk. For more information about options, go to the “Learn Options on a Budget” page under the Resource tab on the homepage of this blog.
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