The Retirement Corporation of America

Frequently Asked Questions:

Q: Can I protect a large concentrated position in one stock against severe drops in price?

A: The first line of defense against severe drops in price on a concentrated stock position is diversification.

An investor can establish a diversification plan with their advisor in order to protect against the price volatility of a single stock. Diversifying funds into a collection of great companies helps to eliminate company-specific risk and provides the opportunity for greater, less volatile returns over the long term.

In some cases, however, tax consequences prohibit the immediate diversification of a stock position. More sophisticated strategies are available to protect these tax sensitive positions.

A simple solution is the utilization of put options to protect against a drop in price. A put option gives the owner of the option the right to sell his shares at a previously agreed upon price. There is a cost associated with the purchase of put options. Your maximum potential loss is limited to the cost of the options.

Another solution is the zero-cost collar strategy. This strategy involves the purchase of a put option in conjunction with the sale of a call option. These two transactions cancel each other out, resulting in a "zero-cost" transaction. If the stock experiences a drop in price, the investor's downside is protected by the put option. However, if the stock rises in price, he may be forced to sell his shares, thus limiting the upside.

"Pre-paid forwards" are a relatively new and sophisticated strategy similar to a zero-cost collar. This strategy involves long term options as well as an investment firm "forwarding" the investor approximately 80% of the value of the concentrated stock position. The investor has limited upside and limited downside on the position throughout the length on the contract. Additionally, he has the ability to invest the pre-paid funds as he'd like. This strategy is not appropriate for every investor.

If you have any further questions about any of the above strategies, please feel free to call us anytime.

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