What is a contingency?
A contingency is a possible adverse event in the future that cannot be predicted with certainty but could harm a company’s operations or an investor’s holdings. Examples include economic recessions, lawsuits, natural disasters, cyberattacks, or sudden supply-chain disruptions. Preparing for contingencies means identifying plausible threats, estimating their impact, and putting measures in place to limit damage.
Key definitions
– Contingency plan: a documented set of actions and roles to follow if a specified negative event occurs.
– Contingent liability: a potential obligation (loss) that depends on a future event (e.g., unresolved litigation).
– Contingent asset: a possible gain that may arise only if a future event is resolved favorably (e.g., a successful lawsuit claim).
– Business continuity plan (BCP): a contingency plan focused on keeping critical business functions running during and after a disruption.
– Hedging: financial strategies (e.g., options, futures) used to reduce the risk of adverse price moves.
– Stop-loss order: an instruction to sell a security automatically once it reaches a set price, limiting further losses.
– Contingent immunization: a fixed-income portfolio technique where managers move to a defensive posture if the portfolio falls below a preset threshold.
Why plan for contingencies?
Insurance and government aid can help, but both have limits. Policies may exclude certain perils (for example, many policies exclude pandemics or specific “acts of God”) and rarely restore lost customers or reputational harm. Government relief can be helpful but is not guaranteed and often arrives only after significant economic stress. Effective contingency planning therefore combines insurance, liquidity management, operational safeguards, and communication strategies.
Core elements of a contingency plan
1. Risk identification — list plausible threats (financial, operational, legal, cyber, natural).
2. Impact analysis — estimate how each threat affects revenue, costs, people, and reputation.
3. Prioritization — rank risks by likelihood and potential loss.
4. Response design — choose mitigation tools: cash reserves, credit lines, insurance, hedges, alternative suppliers, remote-work capability, backups.
5. Roles and responsibilities — name decision-makers and define escalation paths.
6. Communication plan — prepare internal and external messaging (employees, customers, regulators, press).
7. Testing and maintenance — run drills, tabletop exercises, and update the plan regularly.
Short checklist (one-page)
– Identify 10–15 risks relevant to your business or portfolio.
– Mark which functions are critical to keep operating (top 3–5).
– Calculate minimum liquidity needed (cash + available credit).
– Confirm insurance coverage and exclusions.
– Establish data backup and secure off-site storage.
– Build incident-response and PR templates.
– Assign a continuity team and update contacts every quarter.
– Run a simulated disruption at least annually.
Worked numeric example — using a put option as “insurance”
Scenario: You hold 1,000 shares of Company X at $50. You want to limit downside below $45 for three months. A put option with a $45 strike costs $2 per share (premium).
– Cost of hedge = premium × shares = $2 × 1,000 = $2,000.
– If stock falls to $30, you can exercise the put or sell the put for intrinsic value: proceeds = $45 × 1,000 = $45,000; net after premium = $45,000 − $2,000 = $43,000.
– Your loss with the hedge = initial value $50,000 − net proceeds $43,000 = $7,000.
– Without the hedge, loss would be $50,000 − ($30 × 1,000) = $20,000.
Breakeven for hedge = strike − premium = $45 − $2 = $43. If price ends above $45, the hedge expires worthless and your effective cost is the premium ($2,000). This demonstrates the trade-off: protection reduces worst-case loss but costs money and can reduce upside slightly.
Operational examples
Operational examples (continued)
Example 1 — Collar (buy a put, sell a call)
– Setup (positions): long 1,000 shares at $50; buy 1,000 put contracts (1 contract = 1 share in this simplified example) with strike $45, premium $2.00; sell 1,000 call contracts with strike $55, premium $1.50.
– Net premium outflow = premium paid − premium received = $2.00 − $1.50 = $0.50 per share => $0.50 × 1,000 = $500.
– Downside scenario (stock falls to $30):
– Put exercised: you sell (or effectively receive) $45 × 1,000 = $45,000.
– Net proceeds after net premium = $45,000 − $500 = $44,500.
– Loss = initial value $50,000 − net proceeds $44,500 = $5,500.
– Without any hedge (no collar), loss would be $50,000 − ($30 × 1,000) = $20,000.
– Upside scenario (stock rises to $70):
– Short call is assigned at $55, so you effectively sell shares at $55: proceeds $55 × 1,000 = $55,000.
– Net profit after premiums = proceeds − initial cost − net premium = $55,000 − $50,000 − $500 = $4,500.
– Upside is capped at the call strike (less net premium), unlike an unhedged long stock.
– Breakeven (at expiration, ignoring dividends and financing): initial stock cost
+ net premium paid per share. In this example the net premium paid was $500 on 1,000 shares = $0.50 per share, so breakeven = $50 + $0.50 = $50.50 per share.
Profit/loss at expiration (per share), ignoring dividends and financing:
– If S_T ≤ $45 (put is exercised): profit = $45 − $50 − $0.50 = −$5.50.
– If $45 < S_T time value (call premium − intrinsic value), then early exercise may be optimal for the holder.
– Note: this is a rule of thumb; taxes, alternative financing costs, and other factors can affect the decision.
Numeric worked example
– Position: long 100 shares at $60; short 1 call (100 shares) strike $55, expiring in 10 days; call premium quoted at $5.50.
– Intrinsic value = 60 − 55 = $5.00. Time value = 5.50 − 5.00 = $0.50.
– Upcoming dividend = $0.75 per share, payable before option expiry.
– Compare: dividend ($0.75) > time value ($0.50) → holder of the call may exercise early to capture the $0.75 dividend; you (short call) may be assigned and forced to sell shares at $55.
– Consequences: you receive $55 per share (plus the short-call premium initially received), you do not receive the $0.75 dividend, and you give up upside beyond $55.
Practical steps to manage early-exercise/assignment risk
1. Monitor ex-dividend dates: most assignments occur just before ex-dividend dates when short calls are in-the-money (ITM). Set calendar alerts.
2. Check option time value: compute time value = premium − intrinsic value. If upcoming dividend > time value, assignment is likely rational for the call holder.
3. Decide mitigation action (choose one depending on objective and costs):
– Buy to close the short call (buy-to-close) before ex-dividend to avoid assignment. This is the simplest but may cost more than expected; use limit orders.
– Roll the short call: buy to close and sell another call with a later expiry or higher strike to retain the collar but defer assignment risk. Confirm net premium/commission implications.
– Accept assignment and plan for it: ensure cash or margin to deliver shares; understand tax/timing implications and dividend loss.
– Use European-style options (when available) or avoid selling short calls into upcoming dividends if you want to retain shares.
4. Monitor margin: assignment can change your margin profile (selling shares reduces long-equity collateral). Verify with your broker whether assignment would create a cash requirement.
5. Communicate with your broker if you expect corporate actions (spin-offs, mergers) which can complicate assignment.
Checklist before selling calls against stock (covered call / collar context)
– Is the option American-style? (Only American calls have early-exercise risk.)
– Is an ex-dividend date before expiry? If yes, what is the dividend amount?
– Compute time value now; compare with dividend.
– Do you have cash or margin buffer to handle assignment?
– Decide: close, roll, or accept possible assignment; set orders/alerts.
Additional practical notes
– Early exercise chance increases the deeper ITM the short call is and the larger the dividend relative to remaining time value.
– Option Greeks: delta (≈ probability-weighted exposure) and theta (time decay) can help gauge how much time value remains but use the dividend test for assignment risk.
– Commissions and bid/ask spreads matter: closing a
position can cost more than allowing assignment — so always compare the net cost to buy-to-close the short call versus the cost/impact of being assigned (buying or delivering the stock, paying the dividend, and any transaction fees). When spreads are wide the market impact of closing can wipe out the time-value “savings” you hoped to keep.
Worked numeric example — closing vs assignment
– Setup: short 95 strike American call on stock currently trading S = $100. Short call bid = $5.00, ask = $5.40. Intrinsic value = S − K = $5. Time value = mid premium − intrinsic = (($5.00+$5.40)/2) − $5 = $0.20.
– Upcoming dividend on ex-div date: $0.60 per share.
– Transaction costs: assume $0 commissions but round-trip spread cost on closing ≈ ask − bid = $0.40 (practical cost to close immediately).
– Decision test: dividend ($0.60) > time value ($0.20) + expected transaction cost to close ($0.40)? 0.60 > 0.60 -> roughly break-even. If you expect any additional slippage or fee, assignment is more likely than closing. If you can close with a limit order inside the spread, you might keep the $0.20 time value but still risk being assigned overnight.
Key formula (dividend test for early exercise)
– Time value = option premium − intrinsic value.
– Early‑exercise incentive exists if: expected dividend > time value + incremental exercise/transaction costs.
– Note: this is a heuristic, not a probability. Brokers, market makers, and option writers also consider tax, margin, and hedging reasons when exercising.
Practical checklist before ex-dividend and expiry
1. Confirm option style: American vs European (only American can be exercised early).
2. Confirm ex-dividend date and dividend amount (gross cash dividend per share).
3. Compute current time value = option premium − intrinsic value.
4. Estimate transactional costs to close (spread + commissions + slippage).
5. Apply dividend test: if dividend > time value + transaction costs, assignment risk rises.
6. Check your cash/margin buffer to either: (a) buy the stock if assigned, or (b) meet margin calls.
7. Decide: close (buy-to-close), roll (buy-to-close then sell a later-dated call), or allow assignment.
8. Set limit orders and alerts; consider conditional orders: buy-to-close if stock trades above strike by a small threshold before ex-div.
9. Record the trades for tax/recordkeeping.
Order tactics and automation
– Use limit orders to avoid paying the full ask when closing; post-only or mid-price orders can reduce spread costs but may not fill.
– Conditional orders: for example, buy-to-close if stock ≥ strike + $0.05 and there is strike by X) and for ex-div dates 2–5 business days ahead.
Other practical notes
– Delta approximates how option price moves with small changes in stock price and roughly correlates with exercise probability for deep ITM options, but it is not a direct probability of exercise.
– Theta (time decay) shows how much premium the option loses as time passes; low remaining time value increases assignment risk when dividends are present.
– If assigned, your broker will either (a) deliver stock (if short stock obligation) or (b) assign you the short/long position automatically; check your broker’s assignment/DRIP (dividend reinvestment plan) policies.
– Tax and corporate action nuances (e.g., special dividends, stock splits) can change the incentives for exercise; consult tax documentation or a tax professional for specifics.
Example decision flows (simple)
– If dividend ≤ time value: generally safe to hold the short call through ex-div unless you prefer a different position.
– If dividend > time value + transaction costs and you cannot accept assignment: close or roll prior to ex-div.
– If you can accept and manage assignment (want to own stock or have margin): you may allow assignment; ensure cash/margin and plan for the dividend (you will be long/short stock accordingly).
Summary checklist to act in the final days
– 5 days out: confirm ex-div and style; compute time value.
– 2 days out: re-run dividend vs time-value test; set alerts/orders.
– 1 day or the morning of ex-div: if dividend significantly exceeds time value, close or roll; otherwise you may hold.
– After ex-div: check your account for any assignment notices and reconcile positions.