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Legacy stock: pain or prospect?
Michael Turvey, 06/06/2019
A common issue advisors have to deal with is managing legacy stock positions for clients.
Sometimes these positions may represent a substantial portion of a client's assets, which creates concentration risk. Figuring out how to manage these types of situations may create opportunities for advisors to add value for current and prospective clients.
Clients end up with concentrated stock positions that they don't want to part with for a number of reasons. Commonly they may have worked for a company for a number of years, and they don't want to sell the stock for sentimental reasons. Similarly, they may have inherited the position from a passed family member and have an emotional attachment to it. The holder may feel they have a better understanding of the company's fundamentals than the general public and are susceptible to holding shares during secular declines. Clients often have a low cost basis and are afraid of a high tax liability if they sell, or may be dependent on the dividend income the shares produce. Sometimes it might just be fear of missing out on future appreciation. Whatever the reason, it's important to identify it before presenting potential solutions so the pain points are known.
There are several potential avenues to pursue in dealing with concentrated position risk, including systematically selling shares (such as a 10b5-1 plan for company insiders), exchange funds, and stock replacement strategies. One of the more frictionless strategies to consider is using the listed options market, if available. Covered calls could be used to set up potential stock sales while generating income, while protective puts could control downside risk. Equity collars, a combination of covered calls and protective puts, are a popular hedging approach given the potential costs and ability to retain control of shares.
Let's imagine a hypothetical stock that's trading around $124 per share. Suppose the stock has been held for many years, and has appreciated greatly over the past five years (see chart below). If selling shares is not the desired current route, but rather protecting downside risk for the next couple of years in exchange for limiting upside potential, then an equity collar could be considered.
Source: thinkpipes®. For illustrative purposes only
Creating an equity collar essentially consists of three steps:
|1.||Determining a time frame for the strategy|
|2.||Selecting a put strike price to purchase, which sets the level of protection|
|3.||Choosing a call strike price to sell, which caps the upside potential and reveals the position's net cost|
In the option chain shown below, suppose the goal were to protect a position for two years against a drawdown of no more than 20%. This could be accomplished by purchasing a June 2021 $100 strike put, which is 19.2% below the stock's current price. No matter how far the stock may drop, the holder of this put has the right to sell the stock at $100 through the expiration date (each put protects 100 shares). To offset the put's cost a $150 strike call could be sold, which creates an obligation to sell stock 21.3% above the current price. The prices of the two options are similar, so execution and commissions would determine the final cost of the trade, if any.
Source: thinkpipes®. For illustrative purposes only
Every options strategy has risk, and equity collars are no different. One of the main risks to consider is that selling calls creates an obligation to sell stock, which in theory can happen at any time. So if selling shares is not the desired outcome, it's important to pay attention when the short calls become “in the money", particularly around ex-dividend dates when the risk of early assignment increases. Also, as expiration approaches some management decisions will have to be made, depending on where the stock is and the preferred position going forward.
Although many investors claim to understand the concept of diversification, legacy stock positions can be difficult discussions for advisors and clients. Equity collars may be a solution that allows clients to retain control and continue to collect dividends while reducing concentration risk. And they may help buy some time until the tougher decisions on what to do with the stock have to be made.
Commentary provided for educational purposes only. Past performance of a security, strategy, or index is no guarantee of future results or investment success.
The covered call strategy limits the upside potential of the underlying stock position, as the stock would likely be called away in the event of substantial stock price increase. Any downside protection provided to the related stock position is limited to the premium received.
With the protective put strategy, while the long put provides some temporary protection from a decline in the price of the corresponding stock, this does involve risking the entire cost of the put position. Should the long put position expire worthless, the entire cost of the put position would be lost.
Short options can be assigned at any time up to expiration regardless of the in-the-money amount.
Content provided is for educational purposes only and is not intended to be advice for any firm.
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