Strategies for Concentrated Equity Positions
Holding a concentrated investment portfolio is inherently risky.
Some investors, particularly company executives who are compensated in part with shares, can end up with very large positions in one stock.
If you have a large equity position and would like to diversify your holdings, we offer a number of strategies that can help you reduce your exposure.
Purchase of Put Options
When circumstances prevent you from diluting a concentrated equity position, you need a hedging strategy to help protect the value of your investment should the stock price decline.
At the same time, you'll want to be sure that you can share in the stock's upside potential. Put options can help you do both.
Buying a put option is a hedging strategy.
When you buy a put option, you receive the right to sell a stock at a set price on some future date. You are not obligated to exercise the option, but if the stock's market price has fallen below the sum of the put's exercise price and its cost, you'll certainly want to.
On the exercise date, you can sell your stock for the exercise price. If you're unable to liquidate your position for any reason, you can opt to receive a cash payment for the difference between the exercise price and the market price.
Here's how "the strategy" works.
The price you pay for a put option is called the premium.
Let's say that your stock currently trades at $100 per share. You buy an option with an exercise price of $90 per share for a premium of $10. On the exercise date, the stock price has fallen to $70 per share. You can sell your stock for $90, and you paid $10 for the option to do so. You've realized a value of $80 per share, $10 more than the market price.
Hedging costs can vary greatly. The longer the term of protection, the higher the put option's premium. Volatile stocks cost more to hedge as well. When you assume more downside risk, the premium falls. Depending upon your appetite for risk, you can choose the risk/return tradeoff that best suits you.
If unexercised stock options constitute a significant portion of your assets, you face unique challenges.
Such concentrated exposure to one company may represent more risk than you're comfortable assuming. Perhaps you are limited in the steps you can take to diversify your portfolio. Do you want to lock in unrealized gains? PNC Wealth Management can help you unlock the value of options.
More options for your stock options
If your company has rewarded you with stock options, PNC Investments LLC, an affiliate of PNC, is a registered broker-dealer and member of FINRA, and SIPC, can help you exercise these options and realize their value without an upfront outlay of cash. A "cashless exercise" can allow you to reap the financial rewards of your stock options without disturbing your current investment portfolio or securing separate financing.
Prepaid Forward Contract
A prepaid forward contract can help you achieve multiple objectives.
You can protect stock positions against the risk of falling stock prices while still retaining some opportunity to benefit from rising stock prices. A prepaid forward contract will also allow you to generate liquidity for diversification or other purposes.
Use a prepaid forward contract to receive from 75% to 85% of your stock's value in cash.
If you'd like to realize the value of your concentrated stock holding and generate cash without selling your stock, making interest payments on a loan or subjecting yourself to borrowing restrictions based on how you plan to use the funds, a prepaid forward contract may be the solution you need.
Flexible structuring to meet a range of needs
When you enter into a prepaid forward contract agreement, you'll receive an upfront payment in exchange for a commitment to deliver securities in the future. On the settlement date, the number of shares you deliver will be dependent on the stock's market price at maturity.
Since the contract establishes floor and threshold prices that govern how many shares are returned at a given market price, you can help protect your position against downside risk below the floor while enjoying appreciation potential up to the threshold price. You'll have cash in hand to use as you wish -- with no interest payments, no margin calls, and the security of knowing your losses are limited.
Would you like to protect your concentrated equity position from a decline in the stock price but reduce the up-front costs of hedging?
An equity collar strategy uses put and call options to help you achieve this goal while retaining some, but not all, of your position's upside potential.
Create an equity collar hedge by purchasing a put option and selling a call.
When you sell a call option, you collect a premium for giving the buyer the right to buy the stock from you at a specified exercise (or strike) price. If the stock's market price rises above the strike price, you're obligated to sell the stock at the below-market price if the option is exercised.
When you purchase a put option, you gain the right, but not the obligation, to sell a security at a specified price.
Hedge your risk and avoid paying an upfront premium.
You can create an equity collar by purchasing a put with the strike price at or below the current stock price and selling a call with a strike price that exceeds the current stock price. This collar establishes a minimum and maximum value around your equity position for as long as the option contracts are in force. With a zero cost collar, you can structure the hedge so that the premium you generate from selling the call offsets the price you pay for the put option.
Take the uncertainty out of holding a concentrated stock position
With an equity collar, you'll eliminate much of the inherent risk you face by holding a large position in a single stock. You'll be protected against downside risk below the put option price, although the opportunity for unlimited capital appreciation will be capped by the sale of the call option.
Sale of Call Options
Would you like to generate current income from your stock position without selling your securities?
If you don't think your stock is likely to appreciate significantly in value, selling call options might be an effective strategy for meeting your immediate desire for income.
Selling call options is a strategy that works well when you believe your stock won't move sharply in value - in either direction. What a call option won't do is protect you from downside risk.
The seller of a call option gives the buyer the right to purchase a share of stock at a predetermined "strike" price. The seller of the call sacrifices any upside potential beyond the strike price, but benefits by generating current income. The buyer profits from the purchase when the underlying stock's price increases. When the seller owns the underlying stock, the option is called a covered call.
A derivatives-based strategy can help you achieve a variety of investment objectives
Option based strategies can also have many implications in terms of taxation and regulatory issues, for example when insider sales restrictions apply to your holdings. Your PNC investment professional can work with you to design a customized strategy.
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