Investing With Synthetic Bonds

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Ann Lawrence
5 years ago
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1 Investing With Synthetic Bonds Creating and managing forward conversion arbitrage positions I use options to take long positions in equities that I believe will sell for more in the future than today. I use equity options for their inherent leverage to generate short and long-term capital gains. Because of the leveraged nature of these positions, I cannot invest all of my capital in these leveraged trades as it would create too much downside risk. This type of portfolio management means holding a relatively large cash position; on the order of 30% to 60% of the portfolio. The cash amount is just too large to let it sit there. What will I do with this cash? Bonds? In many portfolios there is a need to hold cash to assure that a volatile market cannot wipe out a portfolio. Modern Portfolio Theory (MPT) suggests holding bonds due to their safety and guaranteed income. If bonds are bought at issue and held to maturity, there is no price risk and one would receive the income associated with the bond; virtually no risk to principle or income. While bond prices sometimes move opposite stock prices, most conservative investors are not trying to hedge their portfolios with the directional nature of bond prices. They are simply looking for the price security and guaranteed income. Assume a portfolio that consists of 50% stocks and 50% bonds. The bonds pay 5% and, in a good market, the stocks are earning 10% (mostly capital gains). Blended, the portfolio is earning 7.5%. In a market downturn of 10%, the value of the stocks will decline by 10% and the bonds by 0% for a blended downside of 5%. The bonds have hedged the portfolio downside risk to only half of the market risk. While the market remains down, the stocks are not creating any capital gains, but the bonds are still paying interest. So, this portfolio gains a greater return in a good market than it would lose in a down market. The portfolio is hedged. Why not bonds? Interest rates are not interesting today. Getting reasonable interest rates requires going into riskier corporate bonds and even junk for a reasonable return. Bond markets are obtuse. One cannot simply look into the market at large and make a purchase in the same way we trade equities. Purchasing bonds means going to a bond specialist to find a product with the maturity time and rate needed for the portfolio. Commissions will be relatively high. Not all bonds are marginable. CDs and non-investment grade bonds are not marginable and thus deduct from the buying power of a margin account. Even those bonds which are marginable carry higher margin requirements even in a portfolio margin account. The option trader tends to hold cash in order to have a large buying power in the account making bonds a poor choice for a secure cash replacement. Terry Walters 2018 v13

2 But what about bond funds? Bond funds are marginable securities, but they carry price risk. The risk to the price of the fund overwhelms the relatively small interest rates available in bond funds. Keep in mind that I want a secure price to replace cash. Bond funds defeat the entire purpose of using bonds as a cash enhancement strategy. What is a synthetic bond? The synthetic bond is a combination of stock and equity options that results in a position that has little to no downside risk with a limited amount of potential appreciation over the life of the trade. Since the gains in the trade rely on the underlying stock going up, one needs to improve the odds of picking a stock with a reasonable probability of trading for about 10% greater than today s price two years from now. Picking an underlying Equity: Before entering a position, I need enough information to give me confidence that the underlying product will move favorably for me over the term of the trade. I first check a source of Discounted Cashflow Analysis (DCF). I would like to trade a product selling for less than its FV. If the underlying is trading over its Fair Value and I feel that there is a good reason to believe that the underlying can still do better for the foreseeable future, fine; I ll enter a position. I then check a two year daily chart of candles. On the chart I plot the 50 day EMA and the 100 day EMA. I am looking for a product that has been going up and to the right for the last two years or so. Let s look at Alibaba. It is trading above its FV by about 30% but, I believe there is good reason to believe it is worth a little more based on its plans for the future outlined in the DCF analysis. What this chart says to me is that institutional investors are happy to pay up for this stock. Over the past two years or so, the company management has proven their ability to maintain control of their earnings in a good economic environment. The management has been able to do what they said they would do; they have been meeting their guidance estimates for the last couple of years. This track record has convinced institutional investors that the company will continue and meet their projections. As long as management does not cause the institutional investors to lose faith and the economic outlook is stable, I believe there is a good chance of a price increase.

Contrast that notion with SBUX, TSLA, IBM, GILD or even GE. All have a good story. If you look at their charts though, institutional investors are not buying it.

3 Contrast that notion with SBUX, TSLA, IBM, GILD or even GE. All have a good story. If you look at their charts though, institutional investors are not buying it. Many will say that they will turn around. Life is too short; I am not buying turn around stories. There are plenty of stocks with a two-year chart like BABA. There is simply no need to try to invest long, based on a hunch that things will improve. The uptrending stocks have already proven themselves and the investors believe it. Others will say the trending stock has gone up too high and it is going to crash soon. The only facts that I have don t tell me that. I just need the stock to move up about 10% in the next two years to make money on the trade. A robust global economy, management has proven their ability to control their business, institutional investors continue to give high value to the stock; I believe these conditions warrant owning the stock for a couple of years. As a cash replacement, the trade can t lose, and it could make a bond-like return. Structure of the synthetic bond: Buy 100 shares of the underlying equity. Buy a LEAPS put at about 700 DTE at the money. Sell a LEAPS call in the same month for enough premium to pay for the put. The underlying stock is secured from price risk by the ATM put for the duration of the trade. The call pays for the put so that the trade is even money. The call effectively caps the upside potential of the stock. Thus, the potential gain on the stock is the short call strike minus the long put strike minus the cost of the trade. The spreadsheet used to analyze the trade is available at The BABA example shown here is an actual trade.

4 BABA Trade Date 10/9/2017 Current Stock Price (Buy the stock, 100 shares per 1 Lot) $ Put Strike (Buy To Open) At or near the money 180 Put Price $31.75 Call Strike (Sell To Open) Same as Put Strike or slightly OTM 195 Call Price - If a different strike, then approximately the Put Price $31.75 Lot Size 1 Dividend Cycles Dividend - Quarterly Amount DTE 830 Total Dividends per share for the trade $0.00 Total Potential Dividend Dollars $0.00 Buy Shares - Capital Required $18, Buy Put - Dollars ($3,175.00) Sell Call - Dollars $3, Option Trade - Credit (Debit) $0.00 Max Loss - Not considering Dividends $0.00 Total Cost of Trade $18, Notional Long Put - the "Cash" $18, Notional Long Call- the "Cap" $19, Gain - Underlying trades above Call Strike (includes dividends) $1, Total Return On Capital 8.33% Rreturn On Capital Anualized 3.66% Gain - Underlying is below Put Strike (includes dividends) $0.00 Total Return On Capital 0.00% Rreturn On Capital Anualized 0.00% The trade depends on the price of the options, so to a large extent a product with a relatively high Implied volatility will setup. Several factors are important in the setup. The case shown is unusual in that BABA happened to trade exactly at an available put strike. Additionally, it is coincidental that there was a call strike whose premium was exactly the same as the premium for the long put. Thus, the trade cost is zero. The 100 shares of long stock purchased for $180 are hedged at $180 and no additional cash was required to enter the trade. Above the 195 short call, there is no more to be gained as the long stock is capped off by the short call. The returns are relatively small at about 3.66% per year. Still, since I have cash that I will not be using for the next two years or so, this is far better than simply letting the cash idle. Most products will not set up nearly this well. In many products there is simply no call strike available that will pay for the long put. The AMZN setup is messy, like most, but has a much better return. Note that there is a very slight loss if the underlying trades below the long put at expiration. I considered this a small price to pay and placed the trade.

5 AMZN Trade Date 10/20/2017 Current Stock Price (Buy the stock, 100 shares per 1 Lot) $ Put Strike (Buy To Open) At or near the money 990 Put Price $ Call Strike (Sell To Open) Same as Put Strike or slightly OTM 1100 Call Price - If a different strike, then approximately the Put Price $ Lot Size 1 Dividend Cycles Dividend - Quarterly Amount DTE 819 Total Dividends per share for the trade $0.00 Total Potential Dividend Dollars $0.00 Buy Shares - Capital Required $99, Buy Put - Dollars ($13,605.00) Sell Call - Dollars $13, Option Trade - Credit (Debit) ($75.00) Max Loss - Not considering Dividends $ Total Cost of Trade $99, Notional Long Put - the "Cash" $99, Notional Long Call- the "Cap" $110, Gain - Underlying trades above Call Strike (includes dividends) $10, Total Return On Capital 10.78% Rreturn On Capital Anualized 4.81% Gain - Underlying is below Put Strike (includes dividends) ($294.00) Total Return On Capital -0.30% Rreturn On Capital Anualized -0.13% In A Crash: Consider this position in FB in the spreadsheet below:

6 FB Trade Date 12/26/2017 Current Stock Price (Buy the stock, 100 shares per 1 Lot) $ Put Strike (Buy To Open) At or near the money 175 Put Price $23.33 Call Strike (Sell To Open) Same as Put Strike or slightly OTM 195 Call Price - If a different strike, then approximately the Put Price $23.90 Lot Size 1 Dividend Cycles Dividend - Quarterly Amount DTE 752 Total Dividends per share for the trade $0.00 Total Potential Dividend Dollars $0.00 Buy Shares - Capital Required $17, Buy Put - Dollars ($2,333.00) Sell Call - Dollars $2, Option Trade - Credit (Debit) $57.00 Max Loss - Not considering Dividends $85.00 Total Cost of Trade $17, Notional Long Put - the "Cash" $17, Notional Long Call- the "Cap" $19, Gain - Underlying trades above Call Strike (includes dividends) $1, Total Return On Capital 10.89% Rreturn On Capital Anualized 5.29% Gain - Underlying is below Put Strike (includes dividends) ($85.00) Total Return On Capital -0.48% Rreturn On Capital Anualized -0.23% There is price risk to exit before expiration if the underlying trades below the long put strike. Examine the Risk Profile below. At 746 DTE note that the brown line, indicating today, is well below the red expiration line at 20% below the market. This simply indicates that it will take time for the options to mature to the point where they are approaching the red expiration line. While one could exit the trade early if the underlying trades above the long put, if the underlying is trading well below the long put, one would have to wait until near expiration to exit the trade for the Max Loss calculated at expiration. I have no problem with this exit time limitation as my intention is to put cash away for the next couple of years anyway.

The Effect of Dividends: In the AAPL example below, owning the long stock I will receive dividends. While the annual return of 3.94%, best case, is not great, it is better than sitting on cash.

7 The Effect of Dividends: In the AAPL example below, owning the long stock I will receive dividends. While the annual return of 3.94%, best case, is not great, it is better than sitting on cash. The trade can earn 1.1% annual in the worst case. What if AAPL increases the dividend? Will the effects of lower tax rates and capital repatriation increase the dividend to $1.00? A dividend of $1.00 average, would increase the worst case to 1.94% and best case to 4.99%. I consider this a better choice than leaving money in cash for the next couple of years.

8 AAPL Trade Date 12/26/2017 Current Stock Price (Buy the stock, 100 shares per 1 Lot) $ Put Strike (Buy To Open) At or near the money 170 Put Price $22.30 Call Strike (Sell To Open) Same as Put Strike or slightly OTM 180 Call Price - If a different strike, then approximately the Put Price $21.55 Lot Size 1 Dividend Cycles 8 Dividend - Quarterly Amount $0.63 DTE 752 Total Dividends per share for the trade $5.04 Total Potential Dividend Dollars $ Buy Shares - Capital Required $17, Buy Put - Dollars ($2,230.00) Sell Call - Dollars $2, Option Trade - Credit (Debit) ($75.00) Max Loss - Not considering Dividends $ Total Cost of Trade $17, Notional Long Put - the "Cash" $17, Notional Long Call- the "Cap" $18, Gain - Underlying trades above Call Strike (includes dividends) $1, Total Return On Capital 8.11% Rreturn On Capital Anualized 3.94% Gain - Underlying is below Put Strike (includes dividends) $ Total Return On Capital 2.27% Rreturn On Capital Anualized 1.10% One Year Out or Two Years Out? So far, I have only reviewed synthetic bonds made up of LEAPS options greater than two years to expiration. Late in the year and in early January we have a choice of products with more than 365 DTE. Sometimes it pays to analyze both LEAPS one year and two years out. In the case below GE sets up creating a much higher yield for the one year plus trade if the underlying trades over the short call strike by expiration. Note though, the one year trade can lose about 1.3% if the underlying trades below the long put strike at expiration. The choice is mine to make; higher yield for higher risk or a no risk trade. Since I am looking for a safe place for cash, I have been opting for the safer trade. Note though if GE stops paying a dividend even the safer trade could actually lose money by expiration.

9 GE GE Expiration Date 1/18/2019 1/17/2020 Trade Date 1/12/2018 1/16/2018 Current Stock Price (Buy the stock, 100 shares per 1 Lot) $18.76 $18.29 Put Strike (Buy To Open) At or near the money Put Price $1.51 $2.50 Call Strike (Sell To Open) Same as Put Strike or slightly OTM Call Price - If a different strike, then approximately the Put Price $1.54 $2.40 Lot Size 1 1 Dividend Cycles 4 8 Dividend - Quarterly Amount $0.12 $0.12 DTE Total Dividends per share for the trade $0.48 $0.96 Total Potential Dividend Dollars $48.00 $96.00 Buy Shares - Capital Required $1, $1, Buy Put - Dollars ($151.00) ($250.00) Sell Call - Dollars $ $ Option Trade - Credit (Debit) $3.00 ($10.00) Max Loss - Not considering Dividends $73.00 $39.00 Total Cost of Trade $1, $1, Notional Long Put - the "Cash" $1, $1, Notional Long Call- the "Cap" $2, $2, Gain - Underlying trades above Call Strike (includes dividends) $ $ Total Return On Capital 9.34% 13.97% Rreturn On Capital Anualized 9.19% 6.98% Gain - Underlying is below Put Strike (includes dividends) ($25.00) $57.00 Total Return On Capital -1.33% 3.10% Rreturn On Capital Anualized -1.31% 1.55% Forward Conversion Arbitrage - Make Money Without Underlying Upside Potential: What about a case where I just want to get the gains from the dividends paid while holding the equity? There may be very little chance that an underlying equity will increase in value over the next two years; yet, the dividends paid are worth the investment. Consider also that even though I have picked what I believe to be a winning stock, maybe I want to position the trade so that the underlying does not have to move up for me to make money. There are rare cases where an underlying will setup in a riskless trade with a reasonable return. Consider the GE example below:

10 GE Trade Date 1/7/2018 Current Stock Price (Buy the stock, 100 shares per 1 Lot) $18.57 Put Strike (Buy To Open) At or near the money 18 Put Price $2.27 Call Strike (Sell To Open) Same as Put Strike or slightly OTM 18 Call Price - If a different strike, then approximately the Put Price $3.20 Lot Size 1 Dividend Cycles Dividend - Quarterly Amount DTE 740 Total Dividends per share for the trade $0.00 Total Potential Dividend Dollars $0.00 Buy Shares - Capital Required $1, Buy Put - Dollars ($227.00) Sell Call - Dollars $ Option Trade - Credit (Debit) $93.00 Max Loss - Not considering Dividends ($36.00) Total Cost of Trade $1, Notional Long Put - the "Cash" $1, Notional Long Call- the "Cap" $1, Gain - Underlying trades above Call Strike (includes dividends) $36.00 Total Return On Capital 2.04% Rreturn On Capital Anualized 1.01% Gain - Underlying is below Put Strike (includes dividends) $36.00 Total Return On Capital 2.04% Rreturn On Capital Anualized 1.01% GE has been beaten down and this its option premiums are relatively high. While I don t invest in turn around stories, I might invest in something that does not need to turn around to make money. Notice that in the GE trade, the long put and the short call are at the same strike The short call pays enough that the trade will make about 1% annually no matter what happens. This can t miss combination of long stock/long put/short call is a Forward Conversion Arbitrage position. Stock goes up, stock goes down; no matter the trade still makes money. But wait, there s more. GE pays a dividend shown below:

11 GE Trade Date 1/7/2018 Current Stock Price (Buy the stock, 100 shares per 1 Lot) $18.57 Put Strike (Buy To Open) At or near the money 18 Put Price $2.27 Call Strike (Sell To Open) Same as Put Strike or slightly OTM 18 Call Price - If a different strike, then approximately the Put Price $3.20 Lot Size 1 Dividend Cycles 8 Dividend - Quarterly Amount $0.12 DTE 740 Total Dividends per share for the trade $0.96 Total Potential Dividend Dollars $96.00 Buy Shares - Capital Required $1, Buy Put - Dollars ($227.00) Sell Call - Dollars $ Option Trade - Credit (Debit) $93.00 Max Loss - Not considering Dividends ($36.00) Total Cost of Trade $1, Notional Long Put - the "Cash" $1, Notional Long Call- the "Cap" $1, Gain - Underlying trades above Call Strike (includes dividends) $ Total Return On Capital 7.48% Rreturn On Capital Anualized 3.69% Gain - Underlying is below Put Strike (includes dividends) $ Total Return On Capital 7.48% Rreturn On Capital Anualized 3.69% The addition of the $0.12 dividends for eight quarters provides a return of 3.69%. As long as GE continues to pay dividends the trade makes reasonable returns, but GE does not have to pay dividends to make a little money on the deal. Consider what would happen if GE actually did turn around and began to increase the dividends; better returns. Rolling Up In An IRA: Since trades in an IRA are generally not subject to taxation, rolling the short call up does not cause tax complications. In a taxable account the long put covering the stock constitutes a tax straddle ; in these cases, I will simply let the trade work until the week of expiration and close all positions. I ll let the tax professionals sort out the tax treatment on that. Held in an IRA though the trade can be managed for potential additional gains. In the AMZN example below the underlying has gone up rapidly early in the life of the trade. I could pay to roll up the short call, effectively adding money to the trade to buy a higher short call strike. Rolling the trade up will cost about $5.3K, but moving the strikes up by 100 points generates about $10K additional gain at expiration. The Rolling Ratio in this case is 53%; I have to pay 53 cents to gain 1 dollar at expiration. Should I do this? If I was convinced that AMZN was not going to go back down below the 1200 strike by expiration, I

12 might do it. The annual gain goes up to 6.56%, but I could lose all of the additional money I put into the trade if AMZN crashed. Certainly, such a rolling trade defeats the purpose of setting up a risk free Synthetic Bond, but I should consider that the choice is available while managing the trade. Synthetic Bond Analysis Rolling the Short Call GE Trade Date 1/7/2018 Current Stock Price (Buy the stock, 100 shares per 1 Lot) $18.57 Existing Call Strike 18 Put Strike (Buy To Open) At or near the money 18 Lot Size of Active Trade 1 Put Price $2.27 Date 1/7/2018 Call Strike (Sell To Open) Same as Put Strike or slightly OTM 18 Stock Price $1, Call Price - If a different strike, then approximately the Put Price $3.20 Lot Size 1 Existing Call Price $ Dividend Cycles 8 Pick a higher strike 1200 Dividend - Quarterly Amount $0.12 New Call's Premium $ DTE 740 Total Dividends per share for the trade $0.96 Total Potential Dividend Dollars $96.00 Buy Shares - Capital Required $1, Buy Put - Dollars ($227.00) Sell Call - Dollars $ Rolling Trade Credit (Debit) ($5,300.00) Option Trade - Credit (Debit) $93.00 Additional Gain at Expiration $118, Max Loss - Not considering Dividends ($36.00) Rolling Ratio 4% Total Cost of Trade $1, Notional Long Put - the "Cash" $1, New Total Cost of Trade $7, Notional Long Call- the "Cap" $1, New Notional Long Call- the "Cap" $120, Gain - Underlying trades above Call Strike (includes dividends) $ Max Gain $113, Total Return On Capital 7.48% Total ROC % Rreturn On Capital Anualized 3.69% ROC Anualized % Gain - Underlying is below Put Strike (includes dividends) $ Max Loss ($5,168.00) Total Return On Capital 7.48% Total ROC % Rreturn On Capital Anualized 3.69% ROC Anualized % The Synthetic Bond is far more complicated that I thought, but I have the time and inclination to manage several of them in my accounts. It s better than just sitting on a pile of cash.

Investing With Synthetic Bonds

Investing With Synthetic Bonds Creating and managing forward conversion arbitrage and collared stock positions I use options to take long positions in equities that I believe will sell for more in the