A Conservative Investing Technique To Protect Your Capital

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Includes: SPY
by: Kurtis Hemmerling

Summary

Investing for the first time can be scary.

Many risk averse investors want to protect their principal.

Buying strip or zero coupon bonds and investing the difference in options can protect your capital while giving equity exposure.

This is similar to principal protected notes issued by banks.

Investing in the market for the first time can be scary. You’ve worked hard to budget and save, and now you are throwing it into the big and scary stock market to see if it will get pummeled or come back to you well fed and large. If you are extremely risk averse, but still want some potential equity market returns, here is a do-it-yourself method to protect your investment capital while still having some participation with the equity markets.

  • Step 1: Buy a zero coupon (or strip) bond
  • Step 2: Invest in index options the difference of the bond purchase price and maturity value

If you do this, your principal should be protected by the credit worthiness of the bond issuer. If your index options make zero return, you will at least get your principal back provided the bond issuer doesn’t default. Let us look at an example.

Buying a Zero Coupon (Stripped) Bond

In this example we will buy a principal stripped Treasury Bond that matures in December 31st, 2019.

A strip bonds has the coupon removed. You do not receive regular interest payments. Instead, the bond is purchased at a discount and increases in value over time. So, instead of buying a bond for $1,000 that gives 2% interest (as an example), you would buy the bond at $980 and it would mature at $1,000 in one year without any interest payments being made.

According to this source, the current price for our stated strip bond would be around 96. So if we want to receive $100,000 at maturity (the amount of principal we are protecting), we would buy it for $96,000.

This gives us $4,000 to invest in stock options.

Buying Index Options

For this example we will look at options in an ETF which tracks the S&P 500 (SPY). We want stock options which expire in December 2019. We will choose a strike price which is slightly out of the money. This is the value above which we start to earn a return.

The SPY is currently just below $234. We purchase our call options (or LEAPS because they are long-term) with a $240 strike price. The premium on these options are $2,190 per contract which is for 100 shares. So buying 2 contracts would be $4,380. So in this instance we are risking $380 if our options do not earn a return.

‘What If’ Scenarios

Now a few scenarios could play out.

  1. The US government defaults on bond payments. This seems highly unlikely to me... but if it did happen you have a lot more to worry about than your investment capital. Something big and scary would be going on and I’d probably hide in my bunker with a can opener and tins of food. If this is your worry, perhaps you should be looking into gold.
  2. The index-based options do not earn you a return. You receive your $100,000 principal back in just over 2.5 years.
  3. You get your principal back and you earn a return on the stock options.

How much return could you earn? Let us consider a couple scenarios.

  1. First we will assume that the market goes up roughly 10% per year over the next 2.5 years. The SPY ETF could be as high as $300. Each of your contracts will be worth $6,000 for a total of $12,000. Your annual return is around 4.6% where the market return was around 10%.
  2. The market goes up 5% per year over the next 2.5 years. The SPY ETF hits $265 and your options are worth $2,500 each or $5000 total. Your net return is $105,000 for an annual return of roughly 2%.
  3. In the unlikely instance that the market roars ahead by 15% per year, you would have $118,400 for a compounded annual return of 7%.

The returns could vary though. Option prices can change if market expectations change – for instance if everyone was bullish and expected a strong upside move – your call options could increase in value without the underlying moving. Or the market might move up strong in one year and you decide to close out the position and do something else with the profit. If you close out early you will also receive some of the remaining time value.

Summary

Looking at a highly valued market is scary for first time investors. Usually, after you have been invested in the market for many years, you begin to relax a little as you view bear markets as buying opportunities where your portfolio value will actually increase significantly in a few years time. But when starting out, it is gut wrenching to see years of savings dwindle month after month because of poor market timing or a poorly valued market.

One aspect not considered here is tax consequences. Depending on what type of stripped bond you buy, you will either be paying tax on interest or capital gains. But do your own due diligence.

Also, depending on what your bank offers you, you might chose to pay the extra management fees and buy a structured product that is linked to the market such as a Principal Protected Note (PPN). In Canada we also have Guaranteed Investment Certificate issued by banks which can base your returns on the market (to a certain degree) while protecting the principal. What I am suggesting in this article is not necessarily new, but it is a do-it-yourself system to put you in control and hopefully save a few dollars in fees if you are concerned about market conditions but still want a little of the equity action.

Also keep in mind that you’ll have more capital to invest for higher exposure to the market if you select bonds with maturity dates further out or perhaps issued by corporations instead of the government. But then you need to consider the additional risk you are taking on.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.