# A so-called "perfect strategy"



## hissho (21 June 2006)

Hi all
i heard of this "perfect strategy" 15 months ago and would like to hear some comments:

basically they buy shares with high growth potential and at the same time buy puts ATM with long expiration date to hedge. They use paid dividend to pay for the puts so it "has no downside risk only unlimited upside potential". and because you're "insured" you can gear up to 1 million to buy shares. they require a minimum capital of $25000 to start with. according to their testimonials some clients have grown their portfolio from around $100k up to 1 million thanks to the bull market since 2003. i'm just not too sure what their performance would be like in a bear market...

sounds terrific but according to my extremely shallow knowledge of options, this perfect strategy is synthetic to a bought long call if we draw a payoff diagram...

am i on the right track? any comments?
cheers


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## wayneL (21 June 2006)

Hi Hissho,

As with any strategy, there are *always trade-offs.

Its true that the dividend will pay for "some" of the cost of the put option. But it is also true that you will pay more for a put option where the underlying pays a dividend, than for a put option where the underlying does not pay a dividend.

It does reduce the downside some. As usual the cost of the option comes straight of the bottom line anyway. This cannot be avoided no matter what spin is put on it by brokers/institutions.

Because of the dividend (and providing the option is a long term option) This synthetic call will perform better at expiry than the long call.

The tradeoff is a bit less profit for less risk. But to say there is no risk is a downright lie, or at best, a dishonest spin on the truth.


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## Magdoran (22 June 2006)

Hello hissho,


I agree with Wayne’s comments above.  Each position has trade offs, and there are usually risks and rewards associated with any position.  Sometimes there are low risk arbitrage positions that can occur from anomalies in the market, but these are rare, and often snapped up by professional organisations that specialise in this area.  Hence I’m very sceptical on the concept of a “perfect position”.  My response below is aimed at the generic approach of using synthetic strategies, and not a comment on this particular case.

You are correct in your options theory question about the shape of the risk graph (POD) for this synthetic, in that it resembles a long call.  There is a portion of the risk graph that represents a limited loss.  This is theoretically the maximum loss, then add the associated transactions costs on top.  

With synthetic positions there are some variables to consider.  Firstly, this kind of longer term strategy works best in a strongly up trending market, and requires the stock selected has sufficient projected growth and dividends to make it an attractive consideration.  This will also depend on an assessment of where the market is likely to move – essentially if the bull market will continue, or a correction is likely should form part of the rationale.

The notion of gearing shares in synthetic positions begs the questions as to how to do this.  If a position is on margin, then there are associated costs and risks involved that should be considered.  There may be an ongoing interest component for instance, and the amount borrowed may vary affecting the potential risk.

If the underlying moves bearishly and the puts are not correctly matched to the underlying, there can be losses above the entry and exit transaction and associated costs. If the puts were sold since they gain value in a bearish move, unknowns like volatility and spread risk can adversely affect the outcome too, not to mention how far into the money and what the delta and gamma may look like at exit.  Exercising the puts while they still have time value may cause a loss to of this component, as opposed to selling them. 

The key point here is that when a position is leveraged heavily, there should be a consideration of the real exposure to loss, which could actually be quite substantial because of the magnitude of the position. 

If an investor borrowed half of a $1 million position, they will be exposed to $500,000 risk if the stock went to 0.  Sure, this is unlikely, but the margin has been borrowed, and must be paid back, plus the position is accruing interest against this amount.  If the matching of the puts is wrong, consider the potential for error involved with a $500,000 loan which is owed, and even a small percentage of this can result in a loss that may be considerable.

If long term investment style warrants which yield dividends are used in place of shares on margin, these also have time value costs associated incorporating interest rates, and spread slippage (Wayne refers to this and brokerage as “contest risk”).  The model for matching puts to these kinds of leveraged positions is complicated, and the models often have irregularities depending on time, direction, and magnitude of the underlying price.

Also, Warrants are OTC instruments, and conditions may vary, and there is credit risk involved in these instruments.


Hope this helps.


Magdoran


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## robots (22 June 2006)

hello

is this the strategy being offered by peter spann and mac bank?

using borrowed funds?

this guy's a share guru now

thankyou
robots


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## wayneL (22 June 2006)

robots said:
			
		

> hello
> 
> is this the strategy being offered by peter spann and mac bank?
> 
> using borrowed funds?




That would be the so called "Capital Guaranteed" scheme or something similar.

The risk is cleverley disguised and repackaged as an iniquitous interest rate. Clever, but not quite honest. 



			
				robots said:
			
		

> this guy's a share guru now




LOL Everybody is a guru in a bull market.


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## ctp6360 (22 June 2006)

he needs to become a diet guru and lose some weight!


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## money tree (22 June 2006)

oops!

did somebody forget about the ATO ruling to do with franking credits and hedging?

and what about capital gains?

this sounds like a tax nightmare all round.

the blind leading the blank.

whats the trademarked name of this one........magic woofdog?

and if the share stays still, you get no capital growth while you lose big on the put.......then get a whopping tax bill for ineligable divs

simply genius.........LOL


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## wayneL (22 June 2006)

money tree said:
			
		

> oops!
> 
> did somebody forget about the ATO ruling to do with franking credits and hedging?
> 
> ...




haha yes, good points.

The risk always turns up somewhere else. 

So MT, what you're saying is the ATO disallows franking credits on hedged portfolios?


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## eddievanhalen (22 June 2006)

It's a part of the "45 day rule" Wayne - which applies to those with $5k worth of franking credits (ie you'd need a decent size portfolio)

That ATO rule requires that in order to claim franking credits you need to have held the shares "at risk" for 45 days.  

The definition of "at risk" is to have an exposure equivalent to at least 30% of the risk that you'd have just holding the underlying , so depending on the delta of the put etc.........owning a put on the stock in question may cause you to fail the test.

It may be a little more complicated than that but that's a laymans version anyway.

Ed


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## wayneL (22 June 2006)

OK thanks Eddie.

I must say I'm struggling to see the logic behind it as far as holding a put is concerned.  

Am I missing something?


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## eddievanhalen (22 June 2006)

Not sure if I'm following what you're querying Wayne but for mine it's the government's way of saying "if you wish to claim a $hitload of tax credits then the least you can do is actually take on 30% of the risk of holding the shares "

I assume the government sees imputation credits as a way of encouraging us to invest in Australian companies and compensating us for that risk.  Someone who is out to make a profit and hedge their risk isn't playing fair   

I don't necessarily agree with their argument but that's the way it is. 

Ed


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