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Analyzing A Synthetic Portfolio

|Includes:SPDR S&P 500 Trust ETF (SPY)

One of the problems associated with the synthetic portfolio idea is the uncertainty regarding the amount of leverage being applied, and the extent to which market movements will be exaggerated. It's fun going up, but it's important to ease up on the gas after making a long climb.

Ameritrade very conveniently provides delta as part of their portfolio display, and exports files to Excel very easily. My spreadsheet has a "getprice" function that will get current prices for the underlying. Armed with this information, multiplying contracts X 100 X delta X share price provides $Delta. Briefly, this number predicts that the options position will behave like $Delta worth of stock, over the short run.

Adding beta to the formula develops $Delta Beta, a number that represents the size of a equivalent position in the S&P 500 (NYSEARCA:SPY) index.

Summing up all portfolio positions, portfolio $Delta Beta when divided by actual portfolio value yields a leverage figure. As of today, my synthetic portfolio is still levered 1.23:1 vs. the index. Last week it was 1.73:1.

After doing the analysis last week, I concluded that the leverage was too aggressive for market conditions. Being ahead by approximately 15% on the year, it seems like a good idea to set things up so as not to give it back if the market corrects. Corrective action consisted of cutting outsize positions in Prudential Financial (NYSE:PRU), MetLife (NYSE:MET) and Assured Guaranty (NYSE:AGO) in half.

From there, covered calls were sold over all portfolio positions where there was some premium available with the strike of the call sold in the vicinity of the target price.

Finally, all long LEAPS positions with delta greater than .90 were considered for rolling up. As an example of the type of trade involved, Xerox (NYSE:XRX) Jan 2014 3.0 calls were rolled up to XRX Jan 2014 5.0 calls at a net credit of $1.94. This serves to define downside risk and increases the IRR of the position, due to less funds being deployed. It also makes a better defensive position in the event the market declines.

When taken together, these actions decreased the leverage as discussed earlier in the article. Cash was increased to 43% of the portfolio.

Now what?

I would be more comfortable if the portfolio were deleveraged even further. I've been building a hedge, deep in the money distant expiration puts on SPY. Every time SPY goes up $1, I add another increment to the hedge. If the run continues next week, simply continuing the hedging process will eventually get things down under 1:1 leverage.

Time to Segue from Deep Value to Dividend Growth

I can't resist the word - segway. Just a spiffy word, I knew I could work it in somewhere.

In any event, the funds that have been liberated by the corrective actions above can, in due course, be deployed into more defensive selections. Diagonal spreads on JNJ, OXY, NSC and MMM, done in December last year, are so far in the money that I have very little exposure to further price movement on the underlying.

Seeking Alpha has many articles listing the stocks needed to represent a diversified Dividend Growth portfolio. Checking them against FASTGraphs (where I am a paid subscriber), I can do diagonal spreads on various selections that appear undervalued, in small size.

Once I have some skin in the game, I can do my due diligence and bring the positions up to full size as the situation develops.

Hopefully the market will run up a little further, maybe to 1,540, before heading down.

Disclosure: I am long OXY, NSC, JNJ, MMM, MET, PRU, AGO, XRX.

Stocks: SPY