Risk management contracts covering terms of three to five years may be structured for concentrated shareholders using over-the-counter "FLEX" options.* FLEX options are bought and sold by institutional investors and differ from ordinary exchange-traded options in their longer contract terms, the lack of a ready secondary market, and in the prevalence of European-style contracts, which are settled in cash at maturity.

Protective Puts

Protective Put Options are the "gold standard" for single-stock risk management. Protective Puts give the contractual right (but not the obligation) to sell stock to an institutional investor at a specified price and time. The contract thus guarantees a floor price, called the "strike" price. The underlying stock is not encumbered, which means the shareholder continues to receive any dividends or capital appreciation and continues to vote the shares.

The market value – and the premium cost -- of a put option guaranteeing today’s stock price (“at-the-money”) are typically very high. As a practical matter, therefore, many Protective Puts feature strike prices at about 80% of the current stock price, where their premium cost is a good deal lower.

Collars

Even at an 80% strike price, purchase of a Protective Put for cash is a significant cost. The cash amount required can be reduced or eliminated if the shareholder is willing to pledge the underlying stock and forego upside potential by selling Call Options on it. (Call Options give the contract counterparty the right to buy the stock, and it must therefore be available for delivery at settlement.)

The combination of buying Puts and selling Calls of matching terms is called a "collar," and if the net proceeds from the sale of the Calls equals or exceeds the premium paid for the Puts, the transaction may be referred to as a "cashless" collar.

An options trader familiar with the OTC options market may quote the Protective Put and may also solicit bids on the Call component in the case of a Collar. Pricing depends on the details of the requested transaction, the stock and the notional amount (that is, the dollar value of the shares covered by the option). Price quotations may vary widely from one counterparty to another. Minimum notional amounts of $1 million or higher per transaction and maximum terms of three years may apply.

* FLEX Options should be distinguished from listed options, which are typically American-style options, redeemable at any time up to maturity. Listed options are suitable for shorter-term risk management purposes up to 2-1/2 years and are readily available through any brokerage account. Pricing is readily available through CBOE (see "Analysis" at right). 

In evaluating the purchase of Protective Puts, one should begin by reviewing the expected cost of various available put options as indicated by market-posted "Ask" prices. These are the prices demanded by credit-worthy counter-parties for accepting the risk of a given put. Once the cost of a desirable put option has been determined, one may examine the potential for a Collar by reviewing the Bid prices for call options for the same stock and maturity. (Near-current Bid/Ask pricing for exchange-listed puts and calls are published at www.cboe.com.)

A similar procedure may be used for evaluating longer term protective puts and collars. For this purpose, however, price information generally must be obtained from a dealer. As a starting point, the market value of desirable FLEX options may be estimated using the CBOE options calculator. (Note: This is found under "Trading Tools" and "Volatility Optimizer" on the CBOE web site.)

The options calculator values the option as an asset to the option holder, and this value also represents the accounting value of the option liability to the counterparty. To this value must be added a markup that depends on details of the transaction, the counterparty and the competitive bidding exposure of the available contract.

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