From the October 01, 2012 issue of Futures Magazine • Subscribe!

Profiting with Synthetic Annuities

Profiting with Synthetic Annuities
Option Strategies to Increase Yield and Control Portfolio Risk
By Michael Lovelady
FT Press, 2012
$49.99, 272 pages 

Would you like to invest in stocks or bonds, increase their current yields, and simultaneously reduce, or at least, control downside risk?  As described in Michael Lovelady’s example trades, the promise of his book’s subtitle is carried out effectively. The tradeoff -- other than the work of picking acceptable securities and options and keeping up with the resulting rate and price changes following the trade -- is the sacrifice of varying amounts of upside gains when the underlying security has a rapid price increase.

In the first chapter, the introduction, the author points out problems with traditional portfolio selection and structure, including Modern Portfolio Theory and Mean-Variance-Optimized. Current challenges to those responsible for development and management of portfolios are shown as “how to” problems – how to generate yield in periods of low interest rates, how to control volatility in equity investments and how to limit downside risk.

Lovelady’s approach to the challenges faced in portfolio design involves adding options as long-term structural components. Along with investment in stocks or bonds, the suggested portfolio, called SynA, contains short call options and long put options. One objective is to reduce the cost basis of the investment gradually. Cost reduction is achieved through dividends or interest on the underlying, from the dollars gained from theta (erosion of time value of the call options), and initially from the premiums received on the call options sold. Meanwhile, the puts financed by selling calls provide a cushion of downside protection. If the plan works properly, there is an increase in the periodic rate of return and an investment with lower cost and less risk than outright ownership in the underlying securities.

Because one shortcoming of the synthetic annuity is the need to adjust the short calls or long puts when the underlying price increases or decreases beyond the portfolio manager’s comfort zone  (specified as a “risk budget,” a percentage of the reduced cost basis), the system works best with securities whose market prices are not in sustained uptrends or downtrends. Cost reduction through theta tends to be more important than either dividends or interest income, thus the annuity manager hopes for a continuous decrease in the time value of short calls without sharp price spikes or trends that would require adjustments to the option positions. 

Several types of synthetic annuities are described here. For example, a covered synthetic annuity, CSynA, uses only covered call options and protective put options. As shown by an example investment in Deere & Company stock, the CSynA provides a security that is less volatile with more current income. The author notes that the tradeoff is giving up some potential upside.

For a more experienced options trader, generalized SynAs offer a less restrictive structure, permitting the creation of additional theta by overselling calls and selling puts. An investment profile shows results in terms of probability curves. With a generalized SynA it is possible to have larger credits and a wider range for producing gains than with a CSynA.

Throughout the book, investment profiles are shown as TradeStation charts and numerical exhibits. The exhibits make it relatively easy to follow the author’s example transactions. This is true with a more leveraged generalized SynA that has a beginning net credit significantly larger than the covered version. Leveraging means the possibility of large losses with higher stock prices rather than merely giving up some upside.

Different synthetic annuities are designed for high-yielding stocks, for volatile markets and for more stable market environments. In addition, there are synthetic annuities for the bond market. Instead of reshaping the investment profile of stock ownership, a bond SynA can have as its focus either a directional bet on interest rates or a hedge for an existing bond portfolio. An example bond trade is analyzed using exchange-traded options. The instrument chosen as the underlying security is TBT, because it increases with interest rates and would seem to be a likely hedge in view of current low rates.

Yield is created on volatility in a volatility-squared SynA. This refers to volatility-on-volatility, achieved through short options on an underlying security such as the VXX that is related to volatility – thus. implied volatility on volatility.

In each trade example, Lovelady shows exact numbers of underlying securities, long and short options and results for a wide spread of market prices. Also described are management rules for specific synthetic annuities. For example, three rules of CSynA management in the context of cost basis and delta adjustments are (1) protect principal, (2) manage delta and (3) finance insurance. Satisfying the first rule is accomplished by selling out-of-the-money call options when the stock price falls beyond the point of risk tolerance. In this case, principal protection is chosen over potential profits.

After viewing the carefully designed synthetic annuity trades shown in this book, the reader probably will be tempted to try out the process on other stocks or bonds. Instructions in the text should be sufficient to enable a trader to set up similar annuities, and the author’s description of necessary adjustments will help reduce the investment’s risk.

 

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