Hedging is a useful strategy when the holder of a concentrated position would like to protect against downside risk but would also like to capture either unlimited or a significant amount of potential upside with respect to the stock. There are two major hedging approaches investors can consider:
- Purchase of puts
- Cashless, or zero-premium, collar
The tax characteristics of the shares or other instrument that is being hedged can help determine which strategy will deliver the optimal result for the client.
For instance, a key tax issue that arises when hedging restricted shares and employee stock options is the potential tax inefficiency that can result if the instrument being hedged and the tool that is being used to hedge it produce income and loss of a different character. This problem is called a mismatch in character.
The key point is that the tax attributes and characteristics of the shares or other instrument that is being hedged can influence the decisions as to what hedging tool should be used and how the transaction should be documented.
Purchase of Puts
Investors holding a concentrated position can purchase put options to (1) lock in a floor price, (2) retain unlimited upside potential, and (3) defer the capital gains tax.
Investors usually buy put options with a strike price that is either at or, more typically, slightly below the current price of the stock. The investor pays an amount, referred to as the premium, to acquire the puts.
Conceptually, this is very similar to the payment of an insurance premium. In return, the investor is fully protected, subject to the credit risk of the counterparty, from any loss resulting from a decline of the stock price below the strike price of the put.
The out-of-pocket expenditure necessary to acquire puts can be significant. Therefore, investors often seek to lessen their out-of-pocket costs. Described below are a few ways for investors to accomplish this.
The most common way is to lower the strike price. An at-the-money put will cost considerably more than an out-of-the-money put.
Along similar lines, puts with a shorter maturity will cost less than puts with a longer maturity because the “term insurance” doesn’t last very long.
Another popular strategy is to combine the purchase of put options with the sale of put options with a lower strike price and with the same maturity as the long puts, which is known as a “put spread.”
Another, less frequently used way to lessen the cost of put protection is to use a “knock-out” option. A knock-out put is an “exotic” option that can be acquired only through an over-the-counter dealer.
Cashless (Zero-Premium) Collars
Investors holding a concentrated position can implement what is commonly referred to as a cashless, or zero-premium, collar to (1) hedge against a decline in the price of a stock, (2) retain a certain degree of upside potential with respect to the stock, and (3) defer the capital gains tax while avoiding any out-of-pocket expenditure. The investor retains any dividend income and voting rights.
Cashless collars are a very popular tool that investors around the globe frequently use to hedge their concentrated positions.
When structuring cashless collars, investors buy puts with a strike price that is either at or, more typically, slightly below the current price of the stock. The investor must pay a premium to acquire the puts and in return is fully protected from any loss should the stock price fall below the strike price of the puts.
Simultaneously, the investors sell calls with the same maturity with a strike price that is above the current price of the stock and in return receives premium income. The strike price of the calls is set at the level that brings in exactly the amount required to pay for the puts.
Note that investment risk is reduced but not eliminated. Therefore, although the investor forfeits some of the upside potential of the underlying stock, by using a cashless collar, no out-of-pocket expenditure is required, and this is perceived to be a huge advantage by most investors and their financial advisers.
The concept of a cashless collar is very appealing to many investors and advisers. Nevertheless, investors often look for ways to increase the upside potential that is retained.
There are several ways to lower the cost of the protection:
- Purchase an out-of-the-money put as just described.
- Buy a put with a shorter time to expiration. The protection lasts for less time and will cost less.
- Use a pair of puts, buying a put with a higher strike price of XH and selling a put with a lower strike price of XL. The investor is protected between XH and XL. The sale of puts reduces the initial cost.
- Add exotic features to the option (not found in standard options). For example, a knock-out put expires prior to its stated expiration if the stock price rises above a specified level. This may reduce the protection, and the option will cost less.
- No-cost or zero-premium collars are a common way to lower initial cost, in this case to zero, by giving up some stock upside. A put is purchased and a call is sold with different strike prices selected so the premiums are equal. To increase the upside of the strategy, a call with a higher strike price can be sold. It will cost less, but to maintain the initial zero cost, a put with a lower strike price must be purchased. The upside potential is increased, but the downside protection is reduced.
Prepaid Variable Forwards
A collar hedges the value of the concentrated position. The value of the concentrated position can concurrently be monetized by means of a margin loan.
A prepaid variable forward (PVF) where the hedge and the margin loan are combined in one instrument achieves an identical economic result. The margin loan advanced to the client depends on the precise collar structure and its term.
A PVF, in essence, is an agreement to sell a security at a specific time in the future with the number of shares to be delivered at maturity varying with the underlying share price at maturity. Alternatively, a PVF can be cash settled.