When the stock market is bullish, investors seem to take more risk. At least that's the experience with stock accumulators. These financial derivatives provide buyers with a lot of upside potential when prices are on the rise. Unfortunately, when stock prices fall, the losses can be devastating.
In this article, we're going to provide a brief overview of the stock trading strategy known as stock accumulators. As part of that overview, we'll explain why investors are intrigued by these financial derivatives, how money is made or lost, as well as the elements or structure of the contract itself.
Accumulating Stock
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As the name implies, this investing strategy involves the accumulation of stock over time and was quite popular in the 2006 / 2007 timeframe. With the market decline during the Great Recession, stock accumulators were responsible for destroying a great deal of personal wealth.
The strategy behind the accumulator contract is fairly simple. On the one side of the contract is a buyer that believes a company's stock will trade within a given dollar range for the duration of the contract. On the other side of the transaction is the issuer, who believes the stock price will fall over time.
Generally, investing in a stock accumulator is considered a speculation play. Unlike stock options, these are an obligation to buy and sell shares at the strike price. The contract will outline all of the terms and conditions of the transaction.
Accumulator Contracts
As is the case with any financial derivative, the terms and conditions of the agreement will be spelled out in a contract between the buyer and issuer. Elements of the contract may include:
Reference Shares: this is the name of the underlying asset or security, as well as the class of the security.
Strike Price: also known as the exercise price, this is the price at which the issuer will sell shares to the buyer.
Quantity: the volume of shares to be bought and sold. This includes the quantity over the term of the contract, as well as the maximum number of shares that can be accumulated on any given day.
Knock-Out Price / Kick-Out Feature: this is the upper limit, or maximum price, the security can reach before the agreement is said to be "knocked out." At this point in time, all outstanding shares that have been collected are settled.
Dates: including the dates shares will exchange hands (settlement or accumulation), and the knock-out date, which is the first day a knock-out or a kick-out can occur.
Following the market downturn of 2008 / 2009, newer features found on these contracts may include:
Shorter Duration: products are now sold with durations of three to six months, down from earlier contracts of twelve months.
Margin Purchases: investors were often allowed to buy contracts on margin; newer contracts limit such activities, thereby protecting investors from large losses.
We're going to finish this article with two examples that should help demonstrate how stock accumulators work. In the first example, the stock will rise in price, while in the second example the stock's price will fall.
Example 1: Rising Stock Price
In this example, the buyer enters into a 6 month contract to purchase 100 shares of Company ABC each month for $100 per share. In this scenario, the stock market takes off, and so does the value of Company ABC's stock. After only four months, the stock is selling for $120 per share, and the knock-out clause is activated. The buyer has a profit of:
Stock Value = 400 shares at $120 per share, or $48,000
Purchase Price = 400 shares at $100 per share, or $40,000
Profit on Accumulator Contract = $48,000 - $40,000, or a gain of $8,000
Example 2: Falling Stock Price
In this second example, the buyer enters into a 6 month contract to purchase 100 shares of Company ABC each month for $100 per share. In this scenario, a bear market develops and the value of Company ABC's stock plummets. After six months, the stock is selling for $40 per share and the contract is settled. The buyer has a loss of:
Stock Value = 600 shares at $40 per share, or $24,000
Purchase Price = 600 shares at $100 per share, or $60,000
Loss on Accumulator Contract = $24,000 - $60,000, or a loss of $36,000
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