Protective Hedge Strategies

Diversification is the key to successful investing. When your portfolio encompasses a broad range of asset types and financial sectors, you limit your risk of losing money should one investment option decline sharply.

In some instances, however, an investor cannot or will not diversify. One sees this most often when a privately held company goes public and its executives receive large amounts of restricted company stock. Restricted stock cannot be sold until a certain amount of time passes or certain company benchmarks are achieved. Moreover, even when the sales restrictions end, some top executives want to continue to hold their stock to avoid creating the impression that they have lost confidence in the company’s prospects.

The problem, of course, is that if the company experiences a serious reversal, these people who are multi-millionaires on paper will see their wealth disappear if they cannot or will not sell their concentrated position. During the “dotcom” boom and bust, for example, many individuals who became extraordinarily wealthy literally overnight when their companies went public wound up losing everything.

Stockbrokers who get these people in their clutches may recommend diversifying the concentrated position by using margin to build a portfolio of other investments. The problem is that borrowing against the restricted stock only increases the risk to the shareholder if the value of the stock heads down. The broker thus has a duty to discuss alternatives with the customer, in the form of strategies to hedge against risk of loss.

There are a variety of ways to hedge a concentrated position. One of these is called a zero premium or costless collar. The creation of a collar involves the simultaneous purchase of put options and selling of call options. A put option gives its owner the right to sell a stock at a prearranged price, which is called the strike price, even if the market value of the stock has fallen below the strike price. The sale of call options on the stock gives the buyer of the options the right to purchase the stock. The money, or premium, received for selling the calls is used to pay for the puts, thus explaining the designation "costless."

The shareholder seeking to protect his concentrated position buys put options on the stock at a strike price slightly lower than the current trading price and sells call options on the stock at an agreed strike price set slightly higher than the stock’s current price. This transaction effectively locks in the shareholder’s profits, limiting gains if the stock price goes up but preventing losses if the stock price goes down. Even if the shareholder is so bullish on the stock that he hesitates to limit his upside, it is possible to collar just a portion of his holdings.

If you were in this position and your broker told you about the availability of collars and other hedge strategies, you would at least have been given the ability to intelligently consider your choices. If you then decided to roll the dice and lost, it would be your own fault. But if your broker failed to provide you with any information about protective hedges -- failed to inform you that such techniques even existed – then your broker may well have been negligent and breached his fiduciary duties.

If you lost a substantial amount of money because your stock broker or investment advisor failed to advise you about protective hedge strategies, please contact a financial misconduct attorney at Hermann, Cahn & Schneider in Cleveland, Ohio, today. Our lawyers may be able to help you recover your losses through the security arbitration process.