For most investors, the safety of invested money often becomes the deciding factor while selecting investment options. Any investment product or scheme claiming “capital protection” gets immediate attention, as common investors find the guarantee of their invested capital a great advantage. In reality, it is very easy to create such capital protected investment (CPI) products on your own.
This article assumes familiarity of the reader with options.
Capital Protected Investment (CPI)
“Investments are subject to market risk” is the familiar punchline accompanying advertisements about investments in stocks or mutual funds. It essentially means that your invested amount may increase or decrease in value. While profits are always desirable, investors worry the most about the loss of the money they invested in the first place.
Capital protected investment products don't just provide the upward profit potential; they also guarantee the protection of your capital investment (fully or partially).
A CPI product claiming 100% capital protection assures that investing $100 will at least allow you to get back the same amount of $100 after the investment period. If the product generates positive returns (say +15%), you get the positive return of $115.
How CPI Works
Though it may appear perplexing for common investors, CPI is easy to design. One can easily create a CPI product if they have a basic understanding of bonds and options. Let’s see the construction with an example.
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.
The U.S. Treasury bonds provide risk-free guaranteed returns. Assume a one-year long Treasury bond offers 6% return.
The total return from a bond is calculated by a simple formula:
Maturity Amount = Principal * (1 + Rate%)Time,
where Rate is in 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 will allow 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 = $1,886.8
Alan should invest this amount today in the above-mentioned Treasury bond to get $2,000 at maturity. This secures Alan’s principle amount of $2,000.
The Upside Return Potential
From the total available capital of $2,000, the bond investment leaves ($2,000-$1,886.8) = $113.2 extra with Alan. The bond investment secured the principal, while this residual amount will be utilized for the generation of further returns.
For want of high 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 one such high-risk, high-return investment asset. They are available at low cost but offer very high-profit potential.
Alan believes that the stock price of Microsoft Corp. (MSFT) currently trading at $47 will go higher in one year to at least $51 (increase by around 11%). If his prediction comes true, purchasing MSFT stock will give him the 11% return potential. But purchasing 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 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 sake of easy calculations, assume that one can buy the calculated number of contracts). Total cost = 40 * $2.76 = $110.4.
If Alan’s assumption comes true and Microsoft stock increases from $47 to $51 in one year’s time, his call option will expire in the money. He will receive (closing price - strike price) = ($51 - $47) = $4 per contract. With 40 contracts, his total receivable = $4 * 40 = $160.
Effectively, on 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 the Treasury bond. It is lower than the 11% stock return, but pure stock investment does not offer capital protection.
If MSFT stock price shoots up to $60, his option receivable will be ($60 - $47) * 40 contracts = $520. His net percentage return on total investment then becomes ($2,000 + $520)/$2,000 = 26%.
The higher return Alan gets from his option position, the higher the percentage return from the overall CPI combination, along with the peace of mind of having the capital protected.
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 $110.4 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.
Choices Available in Options
There can be other option instruments to buy, 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 the better potential of high returns.
Since there is no concern of losing the amount used for purchasing options, one can play around with highly 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 the profits if their value increases above the predetermined price levels set by the investor.
Variants in CPI
Depending upon the individual risk appetite, one 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. It leaves more money for options buying, which increases profit potential.
The increased residual amount for 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). Offered by professional investment firms, who pool in money from a large number of investors, they have more money at their disposal to spread across different combinations of bonds and options. Being large-sized, they are also able to negotiate better prices for options. They can also get customized OTC option contracts matching their specific needs.
However, they come at a cost. For example, a PPN may charge a 4% upfront fee. Your protected capital gets 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 towards bond purchase and $5 goes towards option purchase. The option may get 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 remaining $15 from option to you. It will take your net return to ($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.
Benefits of Creating a CPI
Designing own capital protected product allows an investor great flexibility in terms of configuring it as per their own needs, creating it at own convenient time, and allowing full control on it.
One would know the actual profit potential and can realize it when needed based on availability.
Ready-made products may not be launched in the market regularly, or may not be open for investment when an investor has the money.
An investor can keep creating CPI products each month, quarter, or year, depending upon their available capital.
Multiple such products created at regular time intervals offer diversification. If carefully calculated and researched, then the potential for one windfall gain from options is sufficient to cover for many zero-returns over a period of time.
Self-creation does need active market-watch, especially if one is playing in American-style options.
Concerns About CPI
It needs long term buy and hold, depending upon how one configures it.
Demat account maintenance charges may apply and eat into the profits.
Brokerage costs may be high for individual options trading.
One may not get the exact number of option contracts, or bonds of precise maturity.
Lack of experience and professional money management, with ignorant tendency to bet on highly risky options, may lead to zero overall returns.
The hidden loss called opportunity cost of capital hits even with capital protection. Getting no surplus returns from a CPI over three years forces an investor to lose out on the risk-free rate of return, which could have been earned by investing the whole amount only in Treasury bonds. The silent killer called inflation clubbed with opportunity cost actually depreciates the value of capital over a period of time.
The Bottom Line
Capital protected investments can be easily created by individuals with a basic understanding of bonds and options. They offer a good and balanced alternative to direct betting in high-risk high-return options, loss-making ventures in equities and mutual funds, and risk-free investments in bonds with very low real returns. Investors can use capital protected investment products as another added diversification to their portfolio.