# "Buy and hold" synthesis using options



## cuttlefish (17 June 2006)

Hi,

I'm interested in using options to add leverage while mitigating some (but not all risk) to long positions on underlying stocks.   Basically adding leveraging to a value investing approach thats worked for me.

Is there a feasible way to synthesise a buy, hold and forget (for two years anyway) strategy with options (or any other derivatives) that still provides leverage and some downside risk mitigation.  I guess what I'd like to do is generate the equivalent of a partially hedged share portfolio.

e.g. If I wanted to go long on XYZ ltd, their shares are $10.  Instead of buying 50,000 shares for $500,000,  I'd like control 50,000 shares using $50,000, and also somehow limit my risk to around that initial $50,000 outlay.

Assume the shares are currently at low volatility (25% say) and currently not trending (or trending sideways).

The most obvious approach is to buy moderately ITM calls but there's still a fair bit of theta in those (only to be expected I guess). But is that the most sensible way?  The other would be to use calendar spreads of some sort, with mixed strikes and dates, which would give some payback for a short term sideways view to fund the longer view I suppose.  

But I'm pretty novice at the options stuff so curious to hear the thoughts of others on this.

Thanks for any ideas.


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## Magdoran (17 June 2006)

Hello cuttlefish,


I started a new thread a few days ago to address exactly this question entitled “Hedging Portfolios”.  This gives a broad generic overview about some of the measures you can take to protect a portfolio from adverse moves, or at least reduce/control the risk in line with your overall strategy.

Derivatives are suitable for both long term and short term activities.  But wether an individual’s view is long term or short term, derivatives should be handled with care, and an investment/trading plan drawn up about how to manage positions under a range of circumstances.  

This can include diversification in sectors, include overseas diversified investments, managed funds, commodity asset classes, Forex etc, in a coordinated strategy to both take advantage of opportunities, and to control risk from perceived threats through defensive action including hedging.

Just like in short term trading, long term positions need to have defined points to either take or lock in profits, as well as having failure criteria, and perhaps hedging strategies which evolves as the market conditions changer over time.

Profit taking may take the form of liquidating positions, then looking for a re-entry, or if wishing to hold the underlying for the long term, may be in the form of selling calls over the underlying for example, or utilising a range of other approaches available with derivatives to take advantage of pull backs in the market, using the long position for collateral and protection for short term bearish strategies.  

Portfolio protection:  There are measures to protect portfolios which may take the form of selling futures, or buying puts in line with selling calls, or buying index options at specified ratios via a range of formulas depending on the risk strategy adopted.

The idea is to lock in profits at points where the market is likely to correct/pull back, and then reduce the protection in times the market is driving.  This is done though, at the expense of either not being exposed to upside gains during this time, or capping/reducing the potential profits.  

In the case where puts are purchased for protection, and calls are sold to finance the puts, and the market moves bullishly, the danger is that sold calls may move into the money and be exercised (especially if there is a dividend coming up – the call seller may end up owing the dividend).  

The way to deal with calls being excercised is to either sell the underlying the derivatives were protecting or buy new shares on the open market to fulfil the exercised sold call options contracts (either reducing the income, or even at a loss – the cost of protection, although the portfolio appreciation would probably offset this and often result in a net profit – but there are may scenarios to consider here).  

This is not always advantageous depending on circumstances, but the premium gained from the initial sale, plus if sold out of the money, the difference between the strike price and the price of the underlying is also gained.

Another approach for long termers is to consider purchasing long term instalment/endowment warrants.  The idea being that over time the gains are either taken out as realised profits, or added to by expanding the positions (assuming gains are made in the long term), or in the case of the endowment warrants increasing the equity until the entire underlying is paid for over time.  The advantage is that these instruments can yield dividends using leverage, multiplying the income on top of growth.  

Also, there can be favourable tax considerations depending on how the individual structures their tax (suggest consulting a tax professional on these issues).  The interest cost can in some cases be considered an expense for instance.  

Allied with this could be a range of protective measures tailored to protect the leveraged position (futures, options, index options, etc – based on a formularised strategy, and also utilising protection/profit taking/locking in strategies in line with market conditions).

There are other long term strategies that can work too for options such as bull put spreads, or LEPOs (see the Options Mentoring thread post 68). Yes you can buy long term calls, especially OTM ones, and sell either calendar style or diagonally against them, but these need constant management and vigilance, so definitely not set and forget strategies, and you really need to understand time and price forecasting in line with options knowledge to do so.  You can do ratio back spreads, ratio spreads (selling the put not the call! – but beware, these have unlimited risk so not really recommended), as well as other complex positions (maybe even butterflies and condors, but this is more Wayne’s territory).

Hope this is food for thought, but be careful, in each case please assess the risk, and have a plan how to lock in profit, and mitigate risk, and have defensive strategies nutted out to respond to the market conditions.  You may consider seeking professional advice to help you do this.


Regards,


Magdoran


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## wayneL (17 June 2006)

Hi cuttlefish,

The problem you have is that cost of carry (the interest rate component of ITM calls) will be > 10% for 2 years. Therefore, even deep ITM will still will have this component of extrinsic value (plus intrinsic value of course). Ultimately, you will have to cough up a lot more than 10% to do what you want, also increasing the amount you "could" ultimately lose.

You could go along the lines of a long term vertical spread. This will reduce your outlay, but will also reduce your profit potential. These long term options are available in the US (they are called leaps) but you might be struggling here, unless you go for an installment warrant, but seeing as you can't write them, you cannot constuct spreads.

Sails has done some work in this area, so she probably will be able to shed more light on the subject.

<edit> did not see mags post before posting this so sorry for repeating some things.

Cheers


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## cuttlefish (17 June 2006)

Wayne, Magdoran, thanks for the replies.




			
				wayneL said:
			
		

> The problem you have is that cost of carry (the interest rate component of ITM calls) will be > 10% for 2 years. Therefore, even deep ITM will still will have this component of extrinsic value (plus intrinsic value of course). Ultimately, you will have to cough up a lot more than 10% to do what you want, also increasing the amount you "could" ultimately lose.




Wayne are you saying that effectively the price of the ITM calls would have a cost built in equal to a market interest rate applied to the value of the underlying covered by the calls (less premium)?  

If I've understood correctly it makes sense that that cost would be built in (because the capital not allocated to buying the full underlying could be applied elsewhere earning interest, so why wouldn't the option writer factor this interest into the cost as well).

And just to clarify - in my sample scenario,   XYZ is trading at $10, sideways with 25% volatility, interest rates are 5.5%, the stock pays a .50 half yearly dividend.   

My options pricing tool gives me a price for a 2 year $9.50 call of $2.20.

How do I determine the interest component - my logic is that it would be $9.50*5.5% over 2 years = $1.07

So in the $2.20 strike price

$1.07 = interest
$.50 = intrinsic value
$.63 = theta + vega?

How do dividends come into the equation or do they not impact the premium (as long as we're doing this a fair way away from a divident payment) because the call writer theoretically gets the dividend if they were carrying the stock?

And then the second question that comes to mind - what is the likelihood of me finding a market maker or other trader to give me a price close to that theoretical price?  (i.e. am I wasting my time if I think the theoretical pricing tool is giving me any indication of what I'd be able to get at market).

Thanks for the reponses by the way its got me thinking about a lot in relation to it. (I hadn't even thought about the interest component which is pretty naive really    )


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## wayneL (17 June 2006)

cuttlefish said:
			
		

> Wayne are you saying that effectively the price of the ITM calls would have a cost built in equal to a market interest rate applied to the value of the underlying covered by the calls (less premium)?
> 
> *Yes Exactly so*
> 
> ...




To get an idea of the cost of carry component of the ITM call, you can do two things in your strategy modeller.

Set dividends to 0

1/ Tell the software that the underlying is a futures contract (cost of carry is negligable and built into the futures price rather than the call)

2/ Construct the equivalent synthetic call (long stock, long put of the same strike as your call) (you are bearing the cost of carry by being long the stock)

Have a look at the difference in the payoff diagrams (comparing analysis date to expiry date). The cost of carry component of the ITM long call will hit you fair and square in the eye.  

Have fun

Cheers


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## cuttlefish (17 June 2006)

thanks again Wayne - much appreciated.


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## wayneL (17 June 2006)

cuttlefish said:
			
		

> thanks again Wayne - much appreciated.




No worries.

Just corrected some typos and diabolical grammer as well


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## NettAssets (17 June 2006)

It would seem that there are some good profit opportunities in selling calls over a long dated long call or stock in a market like the last week or so.
Take a look at something like Zinifex in April you could have bought a call at 30% volatility and in the last month sold a nearer month one at >70% volatility.(give enought time for the V to dissapate before buying it back)

It might be worth having a "shot in the locker" by buying a far dated option on a stock known for volatility if there is talk of either boom or gloom for a volatility play when the time is right.

Have to have a play on the backtester.


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## cuttlefish (17 June 2006)

I imagine you'd want to be pretty committed on your long or short position though given the lack of liquidity for selling the position   if the market goes against you (if it was a 2yr one).   For those sort of plays 3 or 6 month timeframes might be more appropriate? (I don't know 'cos I'm still figuring this stuff out).  Thats also different to the sort of situation I've got in mind but the volatility argument would definitely still work in both cases. (I think    )


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## sails (17 June 2006)

Hi Cuttlefish,

Wayne and Magdoran have already given you a lot of good information and if there's anything I can add it's where I’ve found synthetics can really help understand an options position and makes it easier for me to compare the various pricing components.  

If a long ITM call is purchased a few months out – as Wayne has pointed out it has an interest component and also theta in addition to volatility built into the price which is effectively the cost of insurance in return for a limited risk trade.   In the case of a long call, interest is effectively paid in advance for the life of that call.

 If the same position was created by purchasing shares and a protective put (at the same strike and month as the long call), this is a synthetic long call.  The difference is that interest is not paid in advance, but it is very likely that theta / volatility in the put will be very similar to theta / volatility in the long call.   Remembering too that further out options have more sensitivity to IV fluctuations - so lower IV is preferable.

So as you can see, it’s difficult to exactly duplicate a long share position even with ITM long calls as there is still less downside risk with a long call and there is the advantage of leverage – both of these benefits come with some extra cost to owning the shares outright.  But then, if we want to leverage the shares, there would be the cost of margin lending interest rates which are higher than official cash rates.

Of course, the other thing to consider is getting out of the position at a fair price if your analysis is correct and the long call becomes even further ITM.  One way out of this is to exercise it and then sell the shares the next day – but you would need to know how your broker handles this as there is one day difference in settling the buy and sell and some charge a fail fee.  Also some Aussie brokers charge full fees on the underlying when exercising and this applies on both the buy and sell which can become quite substantial – not to mention the possibility of capital gains tax without ATO trader status.  Just a case of trader beware!

Certainly nothing wrong with the long call strategy, but as always, it pays to know where the risks are and have a plan in how to handle them.

Just my   - hope it helps!


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## Magdoran (18 June 2006)

Hello cuttlefish,


Wayne made a good point about the costs to enter a long term trade, and you are looking for situations where you forecast that sufficient income from dividends combined with beneficial price movement will cover the costs of the position and exceed these to make a profit.  If not, you must either find other ways of reducing the cost, and/or bringing in income, or determine that the strategy is not viable.

Don’t forget that instalment/endowment warrants that yield dividends over a period of time do so as a leveraged amount (so if you got 10 times the leverage from the amount of shares you would have had, you get 10 times the dividend amount) this helps to offset the costs of the warrant - but the value of the warrant is adjusted as dividends are issued, so beware – the idea is that the stock should be moving bullishly enough in your timeframe.  This is not such a good strategy unhedged in a bear market, and has limited application in a sideways market.

Margaret (sails) makes some relevant points about visualising the POD (Pay off diagram)/risk graph.  A synthetic long has the same shape of risk and reward of a long call.

The alternative to the ITM call, is the way OTM call with a lot of longevity (on its own this is very aggressive, and theta decay is a major enemy of this position, and a wider spread at entry, and potentially wide spread at exit is a drawback if the stock doesn’t move enough towards expiry).  

This strategy involves selling calls in the current month either as a diagonalised bull call spread, as a calendar, or as a diagonalised bull put spread – all with the aim of having these options expire worthless for a mildly up trending stock, financing the OTM call on the way up.  In this case the aim is for the call to be ITM before expiry, reaping significant rewards.

The danger is that the underlying moves strongly upwards too fast while there is still a sold position in the current month, threatening to put the sold position ITM, or the reverse, that the bottom falls out of the stock, and the OTM bought call loses all its value – especially if the stock is unlikely to resume a bullish drive in time sufficient to give it a chance to expire ITM.

The benefit of this approach is that it’s not as expensive as the exposure you have ITM or ATM, and the ratio of returns (if not too far OTM) can be fairly optimal here (aiming for the option to move reasonably ITM).  Be careful though, this needs a lot of time and price precision even for a long term trade to work out well.  It is possible for the OTM position to be too far out, and for it to lose value over time if the stock moves sideways the whole time, or behaves bearishly, so there is considerable risk involved, and may even result in a 100% loss if unhedged (like with the sold diagonal/calendar options).

The way to forecast how options work to make informed choices is to have the capacity to set up a risk and reward chart (POD) and look for the best option based on your view of the market and your model both for the stock movement, and for potential movements in volatility.

Exercising to close out a position:
Just a quick comment on Margaret’s post regarding the idea of exercising an ITM call to get a fair price (this is a great tactic if the market makers are widening the spread too much when you’re trying to exit):  The mechanics of this are that your broker should allow you to place an exercise order, and this should immediately allow you to have access to the number of shares owing from the exercised contract(s) to sell in the market at your discretion (although you will have to pay for them at T+3 as per usual for shares if you wanted to retain them).  

In this case though you’re probably exiting at a high price believing that a pull back or a correction is imminent in the underlying, hence there is power of having the capacity to sell at the time of your choosing (preferably when the time value is rapidly declining in the last 30 days till expiry).


Regards


Magdoran


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## wayneL (18 June 2006)

Exercising to close the trade (presuming we are talking about exercising early) only makes sense if there is zero extrinsic value in the option and the bid is LESS than intrinsic value, (or you exercise to capture a dividend) otherwise you are cheating yourself out of money. 

If there is ANY extrinsic value remaining on the bid, (even if the spread is ludicrously wide) you are far better off selling the call. If you exercise, that extrinsic value goes straight into the pocket of the writer and disappears from your bottom line.

e.g.

call bought for $5.00 some time in the past

call is now $9.00 bid  $11.50 ask, and intrinsic value = $3.50

If you sell the call for the bid you've made $4

If you exersize, you've only made $3.50, forfeiting the 50c to the writer, also exposing you to overnight risk.

There are other ways of closing out the trade depending on the situation. (delta and extrinsic value remaining) 

Cheers


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## sails (18 June 2006)

Thanks Wayne - I did forget to point that out.   Usuallly a good idea to run calculations (including brokerage and fees) on both methods of exit - the differences can be surprising.

The other thing I forgot to point out when comparing long calls to synthetic long calls is that I deliberately omitted dividends due to the complexity they add to the equation.


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## cuttlefish (18 June 2006)

thanks for all of the information, its given me a lot of food for thought. 

The lack of liquidity is definitely an issue for achieving a reasonable exit especially in the event of the underlying moving significantly the wrong way.   The fact that the interest is effectively being capitalised and paid for up front is an issue as well - how do you recover that if exiting early (except by finding a buyer for it - which probably wouldn't be so much of an issue if the underlying is moving in favour but would be if its moving against).

I'm also thinking that maybe writing shorter dated calls against the long calls carries a fair bit of risk and doesn't really capitalise on the low volatility.

I'm going to mull it all over, thanks again for the detailed replies.


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## sails (18 June 2006)

cuttlefish said:
			
		

> ...The fact that the interest is effectively being capitalised and paid for up front is an issue as well - how do you recover that if exiting early (except by finding a buyer for it - which probably wouldn't be so much of an issue if the underlying is moving in favour but would be if its moving against). ...



When you sell to exit the call, the remaining interest should technically still be priced into the call.  The biggest issue again comes back to liquidity where there may be very wide bid/ask spreads from the market makers due to it being so far out, effectively reducing the amount of interest you may get back when you sell.

One other suggestion to get around this is to look at purchasing the initial call closer in time (say around 3 months or as far out as liquidity allows) and then roll the position further out when IV's are on low levels (or up and out if the underlying is up to lock in some profit on the way).  Rising IV around the time you want to roll would be another risk in doing it this way.

 I've found it's often easier to get somewhere nearer the mid price if rolling a position rather than "legging" it by selling one and buying the other separately.  While this helps to reduce the amount of interest paid up front, of course the tradeoff is there are more fees and still some slippage over the same period of time.  

There are so many different combinations and ideas to try out and I think the main thing is to find something that you are comfortable with and know where the risks are and how to manage both profits and losses.  Otherwise, for straight directional trades perhaps CFD's offer a better solution.


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