Synthetic Stocks, Real Returns

Summary

• A synthetic options strategy can be used to replicate the payoff profile of the underlying stock for a fraction of the capital.
• This article details several synthetic overlay strategies which compliment a broader portfolio ideally suited for a semi-active investor.
• A small allocation of two percent to the split-synthetic overlay creates a portfolio with significant outperformance (13.04% annually) compared with passive index holding (8.13% annually).
• The synthetic overlay exhibits only slightly higher volatility and similar draw-down to the all equity portfolio, making it the dominant strategy for even relatively conservative investors.

A few weeks ago, my father called me to discuss the portfolio in his retirement plan. He had some understandable concerns, given that he was heavily weighted in equities for someone his age. A 2008-style market implosion would certainly set him back years. I gave him the vanilla investment advisor response: "You probably should start thinking about allocating towards bonds." There was an audible groan on the other end; he did not want to be out of the game quite yet.

Well, Dad deserved better than some retirement advice you could yank out of a Charles Schwab newsletter. After all those years of his paying college tuition, I felt obligated to give him some ROI on that pricey education. So I decided to set index options to work, and utilize their leverage in testing an overlay. An overlay sits on top of a broad portfolio, and can be used to accomplish investment objectives that are not addressed in a more traditional portfolio. The final product is a strategy dedicated to all dads who reject the white flag of low-yielding bonds.

The Long Synthetic

In that spirit, I will detail an option overlay strategy which allows the investor to participate in a continuing bull market while retaining many benefits of a conservative portfolio. It requires a small allocation of two percent to this strategy in a portfolio that crushes the performance of passive investment in a broad equity index.

The strategy utilizes a long synthetic option trade, which requires purchasing one call and selling one put at the same strike price, and replicates the payoff profile of a long stock purchase. The payoff diagram below shows that in fact this strategy behaves like a long stock, and increases in a linear fashion along with the underlying stock price. The maximum loss of the synthetic occurs when the underlying stock price drops to zero. Generally, option tutorials detail this strategy in terms of selecting a long call and short put option so that they are at-the-money (approximately at 50 delta). In this paper I also explore an alternative-the split-strike synthetic.

Source: Australian Securities Exchange

The split-strike synthetic is often characterized as the "less aggressive" version of the simple synthetic. It differs in that the short put and the long call are both out-of-the-money. The trade-off to being less aggressive compared to the simple synthetic is that it requires a larger upside move in the underlying stock to generate profits. The payoff diagram below demonstrates this notion.

Source: Australian Securities Exchange

The light green line is the immediate payoff of the option position, the purple is the payoff after some time passes, and the teal is the payoff at expiration. If the underlying price lands between points A and B at expiration, the net profit is zero. However, this payoff graph is slightly misleading. A majority of the time this trade is executed for a net credit since the short put is more expensive than the long call (meaning the investor will pocket more from selling the put than he spends buying the call).

An updated graph would reflect a positive net profit if the underlying price were between the put strike A and call strike B at expiration. I take advantage of this differential pricing by incorporating a unique twist to the strategy-a fully self-financing position that invests the net credit from the sold put. This implies that during certain months this strategy may be selling puts and buying calls at a 1:2 or 2:3 ratio. I'll discuss the implications of this pricing later.

Performance

In this section, I address the performance of several strategies with a synthetic overlay. These overlays are bench-marked against a 100% equity portfolio in the Dow Jones Industrial ETF (DIA) and a conservative portfolio holding 75% equity and 25% cash. Data is obtained from the OptionMetrics IVYDB ETF database. The benchmarks are tested against three overlay strategies, which have a portfolio composition of 75% DIA equity, 23% cash, and only 2% dedicated to the synthetic option strategy. This allocation is chosen to emphasize how even a small amount of capital invested in an options position generates significant out-performance compared to passive index holding.

Since the target audience of this paper is only the marginally active investor, this strategy re-balances monthly. Here is my framework for selecting the options:

1. At the beginning of every month, select an option chain with a minimum of 40 days to maturity.
2. Identify a put and call that is closest to the target delta for the defined synthetic strategy.
3. Sell puts and buy calls in a ratio such that options position is completely self-financing. An example is if the put is priced at $1.50 and the call is $0.75, sell one put and buy two calls.
4. At the end of each month, roll the position using the above criteria. Portfolio holdings are re-balanced to maintain the target allocation

The graph and table below highlight the performance of the overlay strategies beginning in May 2002. The blue and orange lines are the cumulative returns of the simple equity and conservative portfolios. The green, red and purple lines are portfolio returns with various synthetic overlay strategies. As an example, the 50-50 synthetic selects a put close to 50 delta to sell, and a 50 delta call to buy.

Strategies	Total Cumulative Returns	Average Annual Returns	Annualized Volatility	Maximum Drawdown
100% Equity	344.6%	8.13%	13.6%	13.6%
75% Equity, 25% Cash	260.2%	6.22%	6.8%	10.2%
50-50 Synthetic (75% Equity,23% Cash, 2% options)	448.5%	9.95%	13.7%	12.1%
80-80 Split Synthetic (75% Equity,23% Cash, 2% options)	360.9%	8.60%	13.6%	12.1%
20-20 Split Synthetic (75% Equity,23% Cash, 2% options)	690.7%	13.04%	16.8%	13.6%

Click to enlarge

Source: Garrett DeSimone, OptionMetrics

The 20-20 is clearly the superior strategy, earning an impressive 690% cumulative return over the sample. At first glance, this result appears surprising given that this is a less aggressive approach to a standard synthetic. The key to the performance of the 20-20 resides in the differential pricing of out-of-the-money (OTM) puts and OTM calls, and the further investment of the net credit in more calls.

A natural phenomenon in options markets is the existence of implied volatility "smile," which is the tendency of OTM put options to be significantly pricier than options that are in the money. During periods of market turmoil nervous investors increase their demand for downside protection in the form of OTM puts, which increases their implied volatilities. On the other side of the curve, the OTM calls do not increase in value as drastically. To assist the reader in visualizing this point, plotted below are the implied volatility curves of DIA options for calls and puts after the large February 2018 selloff. The 195 strike indicates the location of the 20-delta put, and the 205 indicates the location of the 20-delta call.

The higher cost of OTM puts compared to calls generates a larger net credit when the synthetic is created. But in this case, the net credit is reinvested in more calls, which creates a position that sells puts and buys calls at a ratio of 1:2 or 2:3. This can be viewed as a natural doubling-down effect, the benefit of which can be seen in the returns during the volatile post-financial crisis period. In summation, the reason for the 20-20's success is simple- the expensive short put options which finance multiple long calls capture upside momentum, even during periods of turbulence.

Source: Garrett DeSimone, OptionMetrics

Caveats

Because this is a leveraged strategy, there are inherent risks. The primary one involves monitoring the naked put leg of the synthetic. Any naked position will carry margin requirements, and under the Federal Reserve Board's Regulation-T governing margin, it is $5,000 per naked position. With the current level of major ETF indices, I recommend that an investor only engage in this strategy with starting capital of at least $20,000. However, with this amount of capital and the prescribed portfolio allocation, a margin call is unlikely since the cash portion acts as a large buffer during draw-downs.

The other source of possible anxiety from this strategy is the potential for assignment risk during falling markets-the requirement that the options writer be assigned the obligation to deliver on terms of the option contract; in this case, purchase the quantity of underlying equity at the strike price. The selection of a longer maturity expiration at the beginning of each month acts to mitigate this problem. Since this strategy is performed using an option chain closest to 40 days, the option still has time value remaining at the end of each month, making early exercise unlikely. In the worst case, if the investor feels assignment risk is impending, she can close the option position early and roll to open anew at the end of the month.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.