Create your own DIY capital protected investment

Every now and then I would get emails from my broker to ask me to buy some special Capital Protected investments. These products are generally share investments  with a guarantee that your capital will be protected if the share falls below your purchase price, and you can keep any capital gains made if the share goes up in value. It sounds very attractive until you see the interest rate charged for these products! Today I read the production information brochure of one of the products offered by a leading investment bank. The minimum term for the investment is one year and the interest rate for a one year investment comprising of the Big 4 Australian bank shares was 29.88% p.a!

I set out to see if I could do better than that with my own DIY capital protected investment. Today CBA is trading at $47 per share. I had a look at the ASX website and I found I could buy a 13 month $47 put option for around $7 (see table below).With this put option, I would have achieved 100% capital protection which would have only cost me about 15% of the share price. The bank’s product included loaning you the money to buy the bank shares. If I am using this investment strategy using my SMSF funds, I won’t need a loan. If I am doing this outside my SMSF, I could get the money through an investment loan using the equity from my house for around 5-6% so the total cost would be 20-21% which is still 8% less than buying the bank’s product! This extra 8% is probably needed by the bank to pay the financial planners who sell this product plus other administration costs for packaging this product up.

CBA put options

If I want a capital protected investment in CBA shares, I would probably do it a different way. I would buy a 3 month (instead of a 1 year) put option for $3.2 (7% of the share price). At the end of the 3 months, I would do the following:

  • if the share price has risen as I hope, I will buy another put option at the higher price to lock in my gains. For example, CBA goes up to $52 within in 3 months, my $47 put option would be worthless but I would have $5 in unrealised capital gains. I could buy a 3 month $52 put option for around $3 and this will not only protect my original capital but my unrealised gains as well. With a $52 put option, I am guaranteed to be able to sell my shares for $52, even if the price of CBA falls below this value in the future.
  • if the share price has fallen below $47, I would most likely exercise my put option and sell my shares for $47 and look at using the capital on a better investment. My maximum loss would be 7%, which is the cost of my put option.

With the bank’s product, the price of CBA needs to go above $61 ($47 x 1.2988) in one year just for me to break even when I include the cost of the interest. I am locked in to pay this interest for the whole year and I cannot exit early without having to pay all sorts of penalties. That is another reason why I like to make my own DIY capital protected products. If the investment is not working out the way I expected, I can exit early and re-employ my capital elsewhere. I constructed this capital protected investment two days ago. My view of the market as usual, is a little bit contrarion. Most retail investors are saying the new bull market has begun but I think the rally is about to end so I decided to buy a bond ETF because they tend to go up when stocks go down. I bought 200 shares of IEF which is an ETF comprising of a basket of 7 to 10 year treasury  bonds for $89.45 per share and two Sep09 $89 put options at $1.43 per contract. If I am wrong and stocks continue to rally and bonds stay flat or fall, my maximum loss is $376 (or 2% of my investment) as shown in the risk graph below:

IEF risk graph

If you understand options, you can construct your own limited risk products at a fraction of the price sold by major instituitions and have a lot more flexibility with time frames and exits. Check out the Resources page to learn more about options.

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Posted by on Aug 13th, 2009 and filed under Bear Market Strategies, Hedging Strategies, Investment Strategies. You can follow any responses to this entry through the RSS 2.0. Both comments and pings are currently closed.
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