Using Options to Create Capital Protected Investment (CPI)

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

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 means that your invested amount may increase or decrease in value. While profits are always desirable, investors fear losing the money they invested in the first place.

Capital protected investment products provide profit potential, and they also protect your capital investment (fully or partially). A CPI product claiming 100% capital protection assures that investing $100 will at least allow you to recover the same amount of $100 after the investment period. If the product generates positive returns (say +15%), you yield a positive return of $115.

Although it may appear perplexing for common investors, a CPI product is easy to design if you have a basic understanding of bonds and options.

Example of a Capital Protected Investment (CPI)

Assume Alan has $2,000 to invest for one year, and he aims to protect his capital fully. Any positive return above that will be welcome.

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

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

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

If Alan invests $2,000 for one year, his maturity amount after one year will be as follows:

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

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

Here, Maturity Amount = $2,000, Rate = 6%, Time = 1 year, and we need to find 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 total 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 can be used to generate further returns.  Alan has the flexibility to take a high level of risk. Even if this residual amount is lost completely, Alan’s capital amount will not be affected.

Options are high-risk, high-return investment assets. They are available at low cost and offer high-profit potential. Alan believes that the stock price of Microsoft Corp. (MSFT) trading at $47 will go higher in one year to at least $51 (an increase of around 11%). If his prediction comes true, purchasing MSFT stock will give him 11% return potential. However, purchasing an MSFT option will magnify his return potential. Long-term options are available 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 year (June 2016) is available for $2.76. With $113.2, Alan could purchase 113.2/2.76 = 41, rounded to 40 option contracts. (For easy calculation, assume that the calculated number of contracts can be bought). Total cost = 40 * $2.76 = $110.40.

If Alan’s assumption comes true, and Microsoft stock increases from $47 to $51 in one year, Alan's call option will expire in the money. He will 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 comes to ($2,000 + $160)/$2,000 = 8%, which is better than the 6% return from Treasury bonds. It is lower than the 11% stock return, but pure stock investment does not offer capital protection.

If the MSFT stock price shoots up to $60, his option receivable will be ($60 - $47) * 40 contracts = $520. His net percentage return on the total investment then becomes ($2,000 + $520)/$2,000 = 26%. The higher the return Alan yields from his option position, the higher the percentage return from the overall CPI combination, and he will have peace of mind from having protected capital.

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

Other Options Choices

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

Since there is no risk of losing the amount used for purchasing options, the investor can choose risky option contracts provided the return potential is equally high. Options on highly volatile stocks, indices, and commodities are the best fit.

Another choice is to buy American-style options on high volatility underlying. American options can 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 can opt for varying levels of capital protection. Instead of 100% capital protection, partial capital protection (say 90%, 80%, and so on) can be explored. This leaves more money for options buying, which increases profit potential. The increased residual amount for an option position also allows the possibility of spreading the bet across multiple options.

Build or Buy?

A few similar products already exist in the market, which include capital guarantee funds and principal-protected notes (PPN). Professional investment firms pool money from a large number of investors, and these firms have more money at their disposal to spread across different combinations of bonds and options. Professional investment firms can also negotiate better prices for options. They can also get customized over-the-counter (OTC) option contracts matching their specific needs.

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

Additionally, you will never be aware of the actual returns generated from the option position. Assume $91 goes toward the purchase of a bond, and $5 goes toward the purchase of an option. The option may yield a payoff of $30 taking the net return to ($96+$30)/$96 = 31.25%. However, with no obligation to minimum guaranteed returns, the firm may keep $15 for itself and pay only the remaining $15 from the option to the investor. The net return will be ($96+$15)/$96 = 15.625% only.

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

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

There are many benefits to creating a CPI in addition to having protected capital.

Pros

Designing your own CPI allows you greater flexibility in terms of configuring the investment to suit your needs and maintaining full control. You can determine the actual profit potential and can realize it based on availability. Ready-made products may not be launched in the market regularly or may not be open for investment when you have the money to hand.

An investor can keep creating CPI products each month, quarter, or year, depending upon their available capital. Multiple products created at regular intervals offer diversification. If carefully calculated and researched, the potential for one windfall gain from options is sufficient to cover many zero returns over a period. Your own CPI products do not need to be actively watched for market movements, particularly if they include American-style options.

Cons

Nothing is perfect when it comes to investing, and there are concerns associated with 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 may be high for individual options trading. Another drawback is that you may not get the exact number of option contracts, or bonds, of precise maturity. Also, an investor who lacks experience may bet on highly risky 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 could have been earned by investing the whole amount in Treasury bonds. Inflation combined with opportunity cost actually depreciates the value of capital over time.

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.