Using Options to Create Capital Protected Investment (CPI)

For many investors, protecting their investments often becomes the deciding factor when choosing options. Investment products or schemes that claim “capital protection” attract attention as common investors may prefer the guarantee of their invested capital. In point of fact, it is straightforward to create your personal capital protected investment (CPI) products.

Key Takeaways

  • Capital protected investments (CPIs) guarantee the initial capital of investors.
  • A CPI product is straightforward to design for the investor with a basic understanding of bonds and options.
  • Depending on the investor’s appetite for risk, capital protection could be at 100%, 90%, 80%, or less.
  • CPIs come at a value. For instance, a principal-protected note (PPN) may charge a 4% upfront fee.
  • These products require long-term buy and hold.

Understanding Capital Protected Investment (CPI)

“Investments are subject to market risk” is the familiar punchline accompanying advertisements for stock or mutual fund investments. The warning essentially implies that your invested amount may increase or decrease in value. While profits are at all times desirable, investors fear losing the cash they invested in the primary place.

Capital protected investment products provide profit potential, and in addition they protect your capital investment (fully or partially). A CPI product claiming 100% capital protection assures that investing $100 will no less than can help you get well the identical amount of $100 after the investment period. If the product generates positive returns (say +15%), you yield a positive return of $115.

Even though it may appear perplexing for common investors, a CPI product is straightforward to design if you’ve got a basic understanding of bonds and options.

Example of a Capital Protected Investment (CPI)

Assume Alan has $2,000 to speculate for one 12 months, and he goals to guard his capital fully. Any positive return above that shall be welcome.

U.S. Treasury bonds provide risk-free guaranteed returns. Assume a one-year Treasury bond offers a 6% return. The entire return from a bond is calculated by a straightforward formula:

Maturity Amount = Principal * (1 + Rate%)Time,

where Rate is a percentage, and Time is in years.

If Alan invests $2,000 for one 12 months, his maturity amount after one 12 months shall be as follows:

Maturity Amount = $2,000 * (1+6%)^1 = 2,000 * (1+0.06) = $2,120.

Reverse engineering this easy calculation allows Alan to get the required protection for his capital. How much should Alan invest today to get $2,000 after one 12 months?

Here, Maturity Amount = $2,000, Rate = 6%, Time = 1 12 months, and we want to search out the Principal.

Rearranging the above formula: Principal = Maturity Amount / (1+Rate%)Time.

Principal = $2,000/(1+6%)^1 = $1,886.80

Alan should invest $1,886.80 today in Treasury bonds to yield $2,000 at maturity. This secures Alan’s principal amount of $2,000.

The Upside Return Potential

From the entire available capital of $2,000, the bond investment leaves Alan ($2,000-$1,886.8) = $113.20 extra. The bond secured the principal, and the residual amount could be used to generate further returns.  Alan has the flexibleness to take a high level of risk. Even when this residual amount is lost completely, Alan’s capital amount won’t be affected.

Options are high-risk, high-return investment assets. They can be found at low price and offer high-profit potential. Alan believes that the stock price of Microsoft Corp. (MSFT) trading at $47 will go higher in a single 12 months to at least $51 (a rise of around 11%). If his prediction comes true, purchasing MSFT stock will give him 11% return potential. Nevertheless, purchasing an MSFT option will magnify his return potential. Long-term options can be found for trading on leading stock exchanges.

Quote courtesy: Nasdaq

A call option with an ATM strike price of $47 and an expiry date of around one 12 months (June 2016) is offered for $2.76. With $113.2, Alan could purchase 113.2/2.76 = 41, rounded to 40 option contracts. (For simple calculation, assume that the calculated variety of contracts could be bought). Total cost = 40 * $2.76 = $110.40.

If Alan’s assumption comes true, and Microsoft stock increases from $47 to $51 in a single 12 months, Alan’s call option will expire in the cash. He’ll receive (closing price – strike price) = ($51 – $47) = $4 per contract. With 40 contracts, his total receivables = $4 * 40 = $160.

From his total invested capital of $2,000, Alan will receive $2,000 from bonds and $160 from options. His net percentage return involves ($2,000 + $160)/$2,000 = 8%, which is healthier than the 6% return from Treasury bonds. It’s lower than the 11% stock return, but pure stock investment doesn’t offer capital protection.

If the MSFT stock price shoots as much as $60, his option receivable shall be ($60 – $47) * 40 contracts = $520. His net percentage return on the entire investment then becomes ($2,000 + $520)/$2,000 = 26%. The upper the return Alan yields from his option position, the upper the proportion return from the general CPI combination, and he can have peace of mind from having protected capital.

But what if the MSFT price ends below the strike price of $47 on expiry? The choice expires worthless with no returns, and Alan loses your entire $110.40 he used to purchase options. Nevertheless, his return from the bond on maturity can pay him $2,000. Even on this worst-case scenario, Alan is capable of achieve his desired objective of capital protection.

Other Options Decisions

There are other option instruments depending upon the investor’s perspective. A put option is suitable for an expected decline in stock price. Options must be purchased on high beta stocks, which have high price fluctuations offering greater potential for top returns.

Since there isn’t any risk of losing the quantity used for purchasing options, the investor can select dangerous option contracts provided the return potential is equally high. Options on highly volatile stocks, indices, and commodities are the most effective fit.

One other selection is to purchase American-style options on high volatility underlying. American options could be exercised early to lock in profits if their value increases above the predetermined price levels set by the investor.

Variants in Capital Protected Investment (CPI)

Depending upon the investor’s appetite for risk, they’ll go for various levels of capital protection. As a substitute of 100% capital protection, partial capital protection (say 90%, 80%, and so forth) could be explored. This leaves extra money for options buying, which increases profit potential. The increased residual amount for an option position also allows the potential for spreading the bet across multiple options.

Construct or Buy?

Just a few similar products exist already out there, which include capital guarantee funds and principal-protected notes (PPN). Skilled investment firms pool money from a lot of investors, and these firms have extra money at their disposal to spread across different combos of bonds and options. Skilled investment firms may negotiate higher prices for options. They may get customized over-the-counter (OTC) option contracts matching their specific needs.

Nevertheless, these contracts come at a value. For instance, a PPN may charge a 4% upfront fee, and your protected capital becomes limited to 96%. The invested amount will even be 96%, which can affect your positive returns. For instance, a return of 25% on $100 gives $125, while the identical 25% on $96 gives only $120.

Moreover, you won’t ever pay attention to the actual returns generated from the choice position. Assume $91 goes toward the acquisition of a bond, and $5 goes toward the acquisition of an option. The choice may yield a payoff of $30 taking the web return to ($96+$30)/$96 = 31.25%. Nevertheless, with no obligation to minimum guaranteed returns, the firm may keep $15 for itself and pay only the remaining $15 from the choice to the investor. The web return shall be ($96+$15)/$96 = 15.625% only.

Investors pay the costs, yet actual profits may remain hidden. The firm makes a sure-shot profit of $4 upfront and one other $15 using other people’s money.

The Pros and Cons of Making a Capital Protected Investment (CPI)

There are lots of advantages to making a CPI along with having protected capital.

Pros

Designing your personal CPI allows you greater flexibility when it comes to configuring the investment to fit your needs and maintaining full control. You’ll be able to determine the actual profit potential and may know it based on availability. Ready-made products is probably not launched out there recurrently or is probably not open for investment when you’ve got the cash handy.

An investor can keep creating CPI products every month, quarter, or 12 months, depending upon their available capital. Multiple products created at regular intervals offer diversification. If fastidiously calculated and researched, the potential for one windfall gain from options is sufficient to cover many zero returns over a period. Your personal CPI products don’t should be actively watched for market movements, particularly in the event that they include American-style options.

Cons

Nothing is ideal in terms of investing, and there are concerns related to creating CPI products.

These products require long-term buy and hold, depending on their configuration. Demat account maintenance charges may apply and eat into the profits, and brokerage costs could also be high for individual options trading. One other drawback is that it’s possible you’ll not get the precise variety of option contracts, or bonds, of precise maturity. Also, an investor who lacks experience may bet on highly dangerous options and yield zero overall returns.

The hidden loss, or opportunity cost, of capital, applies even with capital protection. If an investor yields zero surplus returns from a CPI over three years, they lose the risk-free rate of return that would have been earned by investing the entire amount in Treasury bonds. Inflation combined with opportunity cost actually depreciates the worth of capital over time.

Pros

  • Greater flexibility in product

  • You haven’t got to depend on market availability

  • There isn’t a limit to the quantity of products created

  • Potential for significant gains

Cons

  • Products call for long-term buy and hold

  • Fees and costs could also be high

  • Betting on high risk options could yield zero returns for novice investors

  • Opportunity cost is an element affecting any gains

The Bottom Line

CPIs are easily created by individuals with a basic understanding of bonds and options. These products offer a balanced alternative to direct betting on high-risk high-return options, loss-making ventures in equities and mutual funds, and risk-free investments in bonds with low real returns. Investors can use CPI products to further diversify their portfolios.

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