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Synthetic Stocks, Real Returns

Mar. 09, 2018 1:08 PM ETSPY, QQQ, DIA11 Comments
Garrett DeSimone profile picture
Garrett DeSimone


  • 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

This article was written by

Garrett DeSimone profile picture
Garrett DeSimone is a Quantitative Research Associate at OptionMetrics, an options database and analytics provider for institutional investors and academic researchers. His current empirical research at OptionMetrics focuses on derivative pricing and macroeconomics. Dr. DeSimone graduated with his Ph.D. in Financial Economics from the University of Delaware, where he served as an adjunct lecturer in finance and economics. He earned a M.S. in Economics and Applied Econometrics from the University of Delaware, and a B.S. in Mathematics from the University of Maryland-Baltimore County.

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.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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