Another Long vs Synthetic Long

Options traders love to pitch "synthetic long" positions as replacement for plain old long stock positions.

Their major claim is that synthetics are more "efficient" than stocks, i.e. they require less capital.
Let's examine the validity of this claim. Let's use the S&P ETF SPY, last year's 12/31/2018 closing price and $7 commissions for our example.

Long:
Buy 100 SPY at 249.92 = $24,992 + $7 commission
Cost of long position: $24,999.

Synthetic Long:
Buy 1 28 June 2019 SPY 250 call at 15.11 = $1511 + $7=$1511
Sell 1 28 June 2019 SPY 250 put at 13.69 = -$1369-7=-$1362
Cost of synthetic long position: $149.00.

Wow. Quite a difference but don't be fooled.

Your broker will require much more than $149 for this options trade. And don't be fooled on the long position either, your broker will "generously" require only 30% or so of the cost to hold the long position. These are called "margin requirements" and this is how they add up:

Long Position Margin requirement: 30% of the stock price x number of shares or
$24,999 x .3 = $7499.70

Initial Synthetic Long Margin Requirement: 20% of the stock price x number of shares + put out-of the money amount + price of the put + price of the call or
100*249.92*.2 = 4998.40 + 0 + 1362 + 1511 = $7871.40

Fast forward to today and let's see what happened. As of this writing:

SPY= 294.23
28 June 2019 SPY 250 call = 44.36
28 June 2019 SPY 250 put = 0

Long gain: $4,424 short-term gain + $266.47 dividends = $4690.47
Synthetic Long gain: $2925 long call short-term gain + 1362 short put gain = $4,287
Difference: $403 to the long position.

We are not yet including your long stock margin loan. If you borrowed the full 70% ($17500) and the rate was 8%, the loan interest over the six month holding period would cost roughly $700. At full margin the synthetic would beat the long position by roughly $300.

This is only one example (you can try 100s and get similar results) but there is apparently very little difference between the two. One major difference is that options expire and stocks don't; another major difference is the risk of exercise of the short put-what a pain that becomes. Over the years, both differences add up. Also how valuable is efficiency anyway when there is little difference between the two.

The efficient claim IMHO is meh.

Feel free to post comments.

Disclaimer: Posts are for education only and not investment advice, may be subject to change without notice, and, while prepared with care, may be subject to omissions and errors.

What IS an annuity? Part 2

So what IS an annuity? Short answer: its where you pay a fee to give all your money to an insurance company and then you pay them fees to withdraw it.

There are actually three basic annuity contracts-variable, guaranteed and income:

• variable: you pay fees to buy a mutual fund and then pay fees to withdraw it;
• guaranteed: you pay fees to buy an uninsured CD and then pay fees to withdraw it;
• income: you pay fees to buy any of the above and pay fees to make regular withdrawals.

Either choice is a bad choice. They are all costly, illiquid and opaque.

• Costly because you can buy the above much cheaper with minimal fees;
• Illiquid because of fees, delays and restrictions in getting out.
• Opaque because of hidden/complex terms and lack of public pricing information.

Plain old life insurance is not included in the bad choice category. Life insurance, even whole life for some, is a wonderful and necessary product. Just as car, house and flood insurance can be. Beware policies that combine life insurance with investments and annuities. Buy your life insurance separately do not let it get bundled/confused with other products

To illustrate my point (illustrate is a favorite but vague term of annuity salesmen), lets look at one particular annuity example:

The simplest offer I could easily find today online is a "single premium-deferred annuity" from one of the rare companies that publicly posts their rates. Their 10 and 20 year rates are 4.30 and 4.35%.

Its identical to a 10 or 20 year CD but its NOT a CD. Its an insurance contract and insurance companies are typically NOT FDIC insured. Firstly, 10 or 20 year certificates of deposit barely exist. Secondly, today's U.S. Treasury 10 or 20 year bonds are yielding less than 3%! 

So they are selling you a 10 or 20 year CD with a "guaranteed" yield of 4.30% or 4.35%. This "guarantee" is backed by the full faith and credit of the INSURANCE COMPANY. But what does the company do with your money other than deduct fees?

Sadly, this company, headquartered in South Carolina, is a subsidiary of a subsidiary of a subsidiary etc. etc. at least according to Bloomberg. The ultimate parent of this particular insurer is a bank in Greece with low-B credit ratings. The company's stated insurance industry AM Best rating is B++.

But that does not tell us what the insurance company does with formerly your money and now its money. Here's a quote from the company's public financial summary (click on the About tab in the link):

"As of December 2018, the portfolio is primarily invested in bonds and has an overall credit quality of 1 or 2 (investment grade), using the National Association of Insurance Commissioners (“NAIC”) financial rating designations, with an average net yield of 5.20%."

Ah yes, they invest in a high yield corporate bond portfolio yielding (as of this date) 5.2%. How nice of them to offer policy holders a return of 4.3 or 4.35%. Frankly, if you really wanted this kind of portfolio, you could buy a great high yield long term bond fund-a Pimco High Yield bond fund today yielding 5.38%* comes to mind.

Let's not pick on this one company (they DO show their rates publicly) it may be one of the better ones out there.

*Individual bonds and bond portfolios,"guarantee their rates", bond fund rates change with prices. Buying individual bonds may be better than buying bond funds.

Feel free to post comments.

Disclaimer: Posts are for education only and not investment advice, may be subject to change without notice, and, while prepared with care, may be subject to omissions and errors.

Market's Up Despite Last Week's Bearish Headlines

The market's way up again as this 1 month DJIA Yahoo screenshot shows.

I don't really want to pick on Barron's because it is one of the best pubs out there for investors, large and small, but they are posting some very questionable advice.

Take the following headline from last Saturday's issue: The Best ETFs for a Choppy Market

Without picking on the usually excellent writer, the entire premise of the story is the fault. This is a "With all this uncertainty, investors who want to take some risk off the table and become a bit more defensive should ..." kind of article.  Why take risk "off the table"?

A critical reader will ask: When is the market NOT choppy? There is always uncertainty and that's the problem.  Anyway how do we know we are taking risk off the table and what are we giving up when we do?

The story then quotes a portfolio manager who says "Investors should aim for “minimum volatility, greater diversification and keeping an eye on asset allocation,’’ to reduce risk. I am not sure this is even possible.  How do you know any certain stock, fund or ETF will reduce risk? Buy and hold indexers know this is impossible.

What we do know is whenever markets fall they historically recover. This is despite Presidents, economies, wars, recessions and depression-such is the nature of our shape-shifting stock market for two centuries. What DOES matter to investors is their need for funds and their ability to wait out any downturns.

Sadly, money managers can only beat indexes when the indexes decline. But these declines don't last and investors who take manager advice usually lose out in the same way that managers underperform.

Feel free to post comments.

Disclaimer: Posts are for education only and not investment advice, may be subject to change without notice, and, while prepared with care, may be subject to omissions and errors.

What IS an Annuity?

Apologies to the Dowager Countess for my heading in response to index-linked annuity advertisements that creep up like weeds whenever the stock market falls.

I believe these ads mislead and are harmful to your wealth. The above is a rough picture of the investment portion of a one year index-linked annuity contract. These expensive and opaque insurance contracts generally offer, for a 1, 3 or 6 year term, a certain amount of "protection" or "shield" from market declines along with a capped share of the gain if the market rises.

This "insurance" strategy can easily be created with exchange traded index options with total transparency, total liquidity, at extremely low cost with NO withdrawal fees and a far smaller margin deposit than any insurance purchase.

The SPY, S&P 500 ETF, chart above shows the profits and loss from a "split strike with short put" options strategy.  It's very much like the "split strike" strategy touted by Bernie Madoff but without the upside.  Whether Madoff is a tip off or not, this is the terrible strategy:

As of today's closing prices, with SPY at 290, (1000 shares = $290,000),
Buy 10 SPY June 2020 (1-year) 290 (at-the-money) Puts for roughly $18.30 or $18,300
Sell 10 SPY June 2020 260 (10% out-of-the-money) Puts for $9.50 or $9,500
Sell 10 SPY June 2020 320 (10% in-the-money) Puts for $35.10 or $35,100

These trades combined will credit your options account with $26,300.
Total commissions at my broker would be roughly $20. No withdrawal fees, no hassle to get in or get out!

This $26K credit is the "protection" against the loss of your real portfolio, which in this example, is the $290,000 invested in the SPY.  This example is slightly less than 10% but you can increase your credit to by adjusting the strike prices of your options.

Why is this strategy so bad? Look at the chart: your losses can be maximized and your gains are limited, the exact opposite what any investor wants. If you really do want protection, forget selling puts and just buy the at-the-money put. This is an insurance policy that costs 6.3% of your portfolio and gives you total protection from the downside with full participation (except for the insurance premium) if the SPY rises.

The chart above is so bad that option traders don't even sell this strategy. You would be hard pressed to find the above options payoff chart online.  Its so bad that only annuity salesmen would sell it.

Feel free to post comments.

Disclaimer: Posts are for education only and not investment advice, may be subject to change without notice, and, while prepared with care, may be subject to omissions and errors.

Commodity Market Lab for May 2019

The Commodity Market Lab pdf for May is posted.

Not much to report this month except tariffs are now going from threat to reality and commodities are reaping the consequences.