This is the second article in a continuing series devoted to strategies designed to reduce portfolio risk, reduce position cost, or both. Many of these strategies involve options replacing some or all of the desired position. They are called synthetics since the shape of their risk/reward profiles are identical to that of the underlying position. Yesterday, for example, we looked at how a synthetic long call, achieved by buying the stock (or futures) plus a put option, can be used as short-term protection against event risk.

Yesterday’s focus was on risk-reduction, but today we’ll be turning our attention to cost reduction which, when you really think about it, is just another way of reducing portfolio risk (since you’re risking less money while expecting the same reward).

Let’s see how we can do that.

Synthetic longs
A synthetic long simulates the risk/reward profile of a long position. It is composed of an at-the-money (ATM) long call and an ATM short put, both with the same shelf lives (expiration dates). The reward is unlimited to the upside, just as a long stock would be. Unfortunately, the risk to the downside is just as great as with a long position, but as we’ll see in a minute, there is a way it can be mitigated in the synthetic strategy.

Let’s consider an example ripped from today’s charts. [Note: Commissions and other costs are not included in the following calculations.]

Google (GOOG) put in a local bottom on March 9th trading around $300. On that day, the June 300 call option closed at $28.40 and the June 300 put closed at $37.00. To buy 100 shares of Google on that day at $300 a share would have cost you $30,000. That’s a chunk of change for such a small position. Let’s see how much the equivalent synthetic position would have cost.

Since 100 shares of stock represents one options contract, it would have cost you ($28.40 – $37.00) x 100 = -$860 to enter the position. The negative number means that you would have actually gotten paid to take on that position. In effect, you’re saving $30,860–gloryosky! How’s that for a reduction in your cost basis?

Let’s see how you would have fared if you had closed out your position two days ago on March 26th.

Google stock closed at $404, so that means you would have made ($404 – $300) x 100 shares = $10,400 for a 35% return. Not too shabby at all.

Now let’s look at the equivalent options position. On March 26th, the call option closed at $104.75 and the put closed at $0.20 giving a profit of ($104.75 – $0.20) x 100 = $10,455. Adding in the cost of the initial credit, your total profit would be $11,315—even better than the stock position. (Actually, I find this quite interesting because the volatility has decreased quite a bit since the beginning of March and I would have expected a lower return.)

So, the choice is yours: Would you rather have spent $30,000 to go long Google or would you rather get paid $860 to reap the same reward for a similar risk? This is the major upside of the synthetic long.

But there are a couple of downsides, too. Sometimes instead of getting a net credit you’ll be paying a net debit to enter the synthetic position. That occurs when the call is more costly than the put. In this instance, you’ll need the stock to rise above the call strike price plus the debit just to break even on the trade. For example, if the price of the call and put options had been reversed in the above example, Google stock would have needed to reach $308.60 just to break even on the trade. This is the one advantage of holding the stock position instead of the synthetic.

Limiting the downside risk on the synthetic
Selling an uncovered option can be a very risky proposition. If Google had continued to slide instead of turning to the upside, the put option would have steadily increased in value while the call decreased in value. The break even point for this trade is $291.40, so you would have been protected until then, but once the stock moves below that point, you’ll start to incur a loss. You can stop this loss by doing one of two things: close the entire position or purchase a lower strike put. You can buy this lower strike put any time, but some prefer buying it when they open the synthetic position. (Buying a lower strike put and selling a higher strike put is known as a bull-put credit spread in options parlance.)

For example, let’s suppose that in addition to our synthetic long we had also bought the June 290 put at a cost of $31. Our cost basis would have swung from a net credit of $860 to a net debit of $2240—still a whole lot less than $30,000. Our break even point would now be $322.40, and that’s quite a difference. It just made the trade riskier on the upside. If we had sold out this position on March 26th, the price of the 290 put was $0.10 so that our overall profit would have been reduced to $8225—a 267% return. [(($104.75 – $0.20 + $0.10) x 100) – $2240 = $8225]

Let’s see what would have happened if this trade went in the reverse direction.

You would lose money if, at options expiration, the stock closed below $322.40. Let’s suppose it was trading at $290 at expiration. Here, all of your options would have expired worthless and you would have been out your initial investment of $2240. Had you just owned the stock, your loss would only be $1000 since you bought it at $300. In fact, you would have done better on the pure stock play even if it had dropped as far as $277.60 but below that the loss on the stock would become greater. The maximum loss for the synthetic position is capped at the initial credit of $2240.

Synthetic short positions
The synthetic short is made up of buying an ATM put and selling an ATM call, both at the same strikes and expiration dates. It’s the same as the above strategy except in reverse. Note that the risk of this position is unlimited just as in the underlying short position. In this case particularly, I would strongly recommend that you write a bear-call credit spread which involves buying a higher strike call. This would greatly reduce your loss should the trade go against you.

Discussion of Risk
While synthetic positions can reduce portfolio risk by reducing the percentage of total dollars allocated to one position, the cost of the position can increase the position risk if the initial cost is a debit. (The position won’t begin to profit until the break even point is reached.) However, if you can enter a synthetic position at a net credit as in the Google example above, you’ve effectively lowered your break even point and decreased your downside risk. Getting into a synthetic position with a net credit (or a small debit) is the best use of the strategy.

Summary
You can see that using options to simulate long and short stock (or futures) positions can be very helpful especially to investors with smaller account values who wish to participate in the movement of higher-priced stocks. Unfortunately, Berkshire-Hathaway stocks (BRK.A, BRK.B) are not optionable.

Much is made about making profits but protecting them is equally important, especially in these uncertain economic times. In that regard, I’ll be writing the occasional article on risk reduction strategies that will show you ways to protect existing positions as well as introducing some low-risk and even riskless trades.

To kick off this series, I’m devoting today’s blog to the discussion of how synthetics can reduce event risk. If you don’t know what any of this means, don’t worry for it will all be explained in due course.

What is a synthetic?
For any conceivable stock or options position there is an equivalent synthetic position that uses a combination of the underlying instrument plus call or put options to achieve an identical risk/reward profile. Although synthetic positions require at least two transactions (and hence two commissions as opposed to one) to set up, they are more versatile in terms of making trading adjustments than their underlying equivalent. With a combination of timing, trading skill, and perhaps a dose of luck, a seasoned options trader can potentially profit from both sides of the trade while still providing the benefits of lowered risk and, for the cases where the underlying is completely replaced by options, a lower entry cost.

Today we’ll be looking at one way you can protect an individual stock (or futures) position using synthetic calls and puts.

Synthetic calls
The synthetic call is used to protect long positions on optionable stocks and futures contracts. It is constructed by buying the stock and an equivalent number of at-the-money (ATM) put options. (Remember that 100 shares of stock = 1 options contract.) The synthetic call is just another name for a protective put. The risk/reward profile is identical to that of a long call. (Click here to see the profile of a synthetic call.)

Let’s look at a recent example of how using a synthetic call on the SPY would have worked just before the release of yesterday’s Consumer Confidence Index.

Suppose you’re bullish on the direction of the market and have been holding a long position in the SPY, the S&P 500 tracking stock. You knew the Consumer Confidence report would be released on Tuesday, May 26 at 10am ET and were (justifiably) concerned that a bad number could derail the market and wipe out your gains. What could you have done to ease your mind and protect your position?

Just ten to fifteen minutes before that number was to be released, you could have picked up the June 85 put for $2.85 to $2.95 per contract and sold them ten minutes after the release for $2.25. This put insurance would have cost you 65 to 75 cents per share, but it was more than covered by the corresponding gain in your SPY position ($1.12 – $1.46 during the 9:45am to 10:10am timeframe). Your net gain would have been in the 37 to 81 cents per share range—a pretty decent return in less than a half an hour! Of course, no profit is realized until the underlying stock is sold, but at least you were protected against potential damage had the number been bad.

And what if the Consumer Confidence number had been ugly? Had the market turned negative, your put would have become more valuable, offsetting the loss in your stock. In fact, the maximum loss you could ever incur with this strategy is limited to the price of the puts plus commission costs whereas your maximum loss without put protection is equal to your entire initial investment. I’d say that’s worth it.

When to initiate put protection
The above example shows how the synthetic call would have worked for a key economic event. Other events where this strategy makes sense is on a stock where a negative or an even less than stellar earnings report could push it over a cliff (think Apple (AAPL) or Google (GOOG)). Also, drug companies with key drugs nearing the end of a study phase also make good protective put candidates especially small biotechs with only one or two drugs under development.

I could have used protective puts in two stocks in my M&A portfolio. When vacation timeshare company Bluegreen (BXG) announced that the company seeking to acquire it needed more time to do their due diligence, that was when the alarms went off and  I should have bought a protective put. It sure would have saved me from a 53% loss I finally had to swallow!  The other position I should have protected was Rohm-Haas (ROH). When acquiring company Dow Chemical (DOW) announced that it was having financing difficulties was the time to protect the position. (As it turned out Dow made good on the deal and I was spared another humiliating loss, but it came at the expense of a lot of mental anguish.)

What type of protection to buy
Now that you know when to buy protection, what strike and expiration should you go for? If you’re looking only for very short term protection like in the above example, buy the front-month option with the requirement that you won’t be holding it for more than a couple of days, max. The reason for a short holding time is that options begin rapidly losing time value about 30 to 45 days before expiration. On the other hand, if your underlying stock is highly volatile and you think there’s a good chance you could profit from an increase in the price of the option, then I’d purchase one with an expiration date at least three months in the future.  This gives you more time without having to worry about time decay eating away at the value of your option, but it probably won’t do much to help you with the issue of decreasing volatility which also affects options pricing.  An option can lose value even if the stock does nothing because of a decrease in volatility, so keep that in mind, too, especially since the volatility of the overall market has been declining.  

As for the strike price, it depends on how much insurance you want and what you paid for the underlying. If your stock has increased in price, you could purchase a put with a strike near the initial cost. The lower strike option will be cheaper but now you risk losing all of your current profit. In buying insurance, there’s always a tradeoff between cost and risk. The choice is up to you.

Synthetic puts
The synthetic put can be used in a similar fashion to protect short positions. In this strategy, you would buy the equivalent number of call contracts to balance your short position. Here, the risk/reward profile is the same as for a put option. Your maximum loss is limited to the price of the call plus commissions whereas the maximum loss of a short position is theoretically unlimited. It’s for this very reason that synthetic puts are a good idea, especially in these volatile markets.

Summary
We’ve seen that event risk can be mitigated by the judicious application of options. As with any options strategy, please paper-trade it first before putting on real money.

Here’s to a more restful night’s sleep!

I’m feeling a bit burned out writing about market timing as applied to modern portfolio theory and thought I’d divert my attentions to what’s happening in the here and now. In the course of chart surfing today, I came across a couple of  interesting stocks that deserve a mention. Consider this a palate-cleansing blog both for you and for me.

Two stocks on the warpath
The first stock that has been blazing an upward trail is small-cap Chinese wireless provider, KongZhong (Nasdaq: KONG). Its daily chart below shows that its been a juggernaut, moving steadily upwards since its 10/10/08 low at $2.31. It closed today at $7.63, up over 230% on more than six times normal volume.

Apparently, somebody knows something. Volume for the past month has, for the most part, been trouncing its normal volume of 95,000 shares. Previously, institutional ownership has been a neglible 0.20% of the float, but perhaps that’s changing. Could it be that someone besides the one analyst covering it is paying attention to the fact that the company has been steadily raising guidance over the past several quarters?

Note that the stock tends to bounce off its 30 dma (the blue line). Right now, it seems to be a bit overextended so if you want to play it, you might want to wait until it pulls back. Also note that if you look at KONG on a weekly chart you’ll see that it faces resistance at the major dollar levels of $8, $9, and $10.

The second is Diedrich Coffee (Nasdaq: DDRX). It was one of the coolest coffee haunts in the ten block commercial corrider near me (as well as the closest) that included one Peet’s, three Starbuck’s, one Coffee Bean and Tea Leaf, one Seattle’s Best (my favorite spot that ultimately morphed into a trendy baby clothing store), plus an independent gourmet espresso shoppe. Starbuck’s (SBUX) eventually bought out all of the Diedrich’s shops in the Southern California area including mine and finally had to shutter because it couldn’t compete with the other two SBUX’s that were within 100 yards of it.

So, I’m scratching my head looking at the chart below and wondering what is suddenly up with Diedrich’s. The company has been closing out its retail locations, including its Gloria Jean brand, and going the wholesale route. The stock chart looks like the 50-1 Kentucky Derby winner, Mine That Bean. Just two months ago it was trading at all of 38 cents, and today it closed at $12.56, only 3200% above that. Guess the insiders who bought near the stock low knew what they were doing–talk about winning the trifecta!

The company’s major competitors are Starbuck’s (SBUX), Peet’s (PEET), and Green Mountain Coffee Roasters (GMCR). Perhaps Diedrich’s management understood that real-estate was in a bubble and wisely sold out. I don’t know about that, but I do know that its stock chart is defying those of its competitors and is the only one trading at an all-time high. Can it keep up this pace? I’m not sure but it looks like somebody’s gobbling up the stock as it’s been trading well above its average daily volume of 120,000 shares for the past three weeks.

The stock may be ready for a breather as evidenced by today’s topping tail. Waiting for a pull-back before entering a long position wouldn’t be a bad thing, especially as the stock has enjoyed a huge run-up.

But I still want to know the inside scoop with this company. Something’s brewing, and it’s not just java.

Note:  Dr. Kris has no positions in any stocks, options, or ETFs expressed in her articles unless otherwise stated.  The exception is with her M&A  (MANDA) fund in which she does own shares as stated.

The recent collapse in the financial markets was the final nail in the coffin for the traditional buy-and-hold strategy. Not only do I believe it, but so does virtually every talking head in the financial media—even Jim Cramer thinks it’s a trader’s market. To some, the term “trader’s market” conjures up java-jolted post-teens on their Wii stations buying and selling equities with a holding period measured in milliseconds. That’s day-trading to the max and not what is meant by a “trader’s market.”

The term is used by most to convey a holding period of days to months, or as long as current market conditions remain valid. On that point, I wondered how applying a market timing scheme to the tenets of Modern Portfolio Theory would affect portfolio risk and return.

To that end, I appealed to Professor Pat whom my readers may remember as contributing many articles to the Stock Market Cook Book last year on the topics of Modern Portfolio Theory (MPT) and Post-Modern Portfolio Theory (PMPT). Pat also wears another hat—that of ace website designer and expert programmer. Who better to tackle this problem?

And that he did. The result of which is the SMC Analyzer, a powerful tool that can be used not only for portfolio analysis but also for market research. Over the next couple of weeks I’ll be using the Analyzer to provide you with market insights that have never been published before, to the best of my knowledge.

Today I’m going to show you how a market timing scheme beats the pants off of the traditional strategy of buy-and-hold.

Bye-bye Buy-and-Hold
The past ten years in the market has been brutal on many retirement accounts where the concept of buy-and-hold reigns supreme. Witness the two nasty downturns in the S&P 500 (chart below). The bursting of the dot-com bubble in 2000 and the mortgage meltdown in 2007 both slashed market capitalizations roughly in half.

Where would that have left the investor? Let’s compare the damage it would have done on two portfolios where the assets are allocated according to MPT guidelines: one that employs a market timing scheme versus a buy-and-hold strategy.

Market timing criteria
In developing a market timing scheme, we found the Commodity Channel Index (CCI) to be an excellent timing oscillator. When the CCI turns positive, the market is trending up. When it turns negative, the market is trending down. (The Analyzer also has the capability of using the rate-of-change (ROC) and the moving average convergence/divergence (MACD) indicators as timing tools. I prefer the CCI because it tends to give the best results over a wide range of inputs.)

The Analyzer uses monthly data for each of these nine asset classes: Large-company stocks (e.g., the S&P 500), small-company stocks, long-term corporate bonds, long-term government bonds, medium-term government bonds, Treasury bills, Real-Estate Investment Trusts (REITs), international stocks, and international bonds.* A separate CCI indicator is computed for each asset class and the averaging period is re-optimized every month. (This is a computationally intensive process, by the way.) The result is that when the indicator is positive, the investor would be long the percentage of that asset class as determined by MPT; and if the indicator falls below zero, the investor has the choice of either shorting (if appropriate) or putting that portion of the portfolio into a risk-free asset such as T-bills.

There is only one user input to the MPT part of the asset allocation calculation: the desired average annual portfolio return. Needless to say, the higher the desired return, the greater the associated risk. Let’s take a look at how applying a market timing scheme to an MPT-generated portfolio compares with a buy-and-hold strategy.

Market timing kicks buy-and-hold butt!
The chart below compares a buy and hold portfolio with one using a market timing scheme we call Long/T-bills. That is, when the CCI indicator for that asset class is positive, we’re long in that class according to the portfolio percentage as calculated by MPT. When the CCI turns negative in that asset class, we move into T-bills according the percentage specified by MPT.

Let’s look at the case where we want an average annual 10% compounded return, and let’s see how we would have fared through the previous two market downturns.

Beginning in 1990 with a $1 in each portfolio, the one based on market timing did in fact give us close to the 10% desired return whereas the buy-and-hold portfolio only returned a measly 4.2%, not even half of what we wanted. Even more surprising is how much riskier a buy-and-hold strategy is compared with a timed one; the risk parameter, as measured by the standard deviation of actual returns, is more than double (15.8% compared with 6.9%). Wow!

What this graph is showing us is how very detrimental a major downturn can be to a buy-and-hold portfolio. The moral of this story is that it pays to cut your losses when they’re small before they get to be so large that it would take many, many years to get back to previous peak values.

Conclusion
I’m really glad my thesis paid off in the creation of the SMC Analyzer because now there’s an analytical tool to help us realize our portfolio goals at reduced risk. I believe this to be a major advance in asset allocation theory. Some of the results from the Analyzer are mind-blowing, especially seeing how different market strategies impact portfolio returns. We’ll be discussing these in upcoming blogs. These next few weeks will be exciting indeed!

For further reference:
To learn more about Modern Portfolio Theory, please refer to Professor Pat’s excellent articles found in the blog archives published on these dates: 4/21-24/08 and 6/2-3/08. You can also find out more in the SMC Analyzer Features Tour.

*In the Professional version of the Analyzer, users have the option of adding their own asset classes—a very nifty feature!

This is how folks from Hawaii, Tibet, Zimbabwe, and Iceland say welcome but no matter where you’re from, I want to extend a warm welcome to my current blog followers and to all of you newcomers to the new home of the Stock Market Cook Book. I’m very proud of it and am very excited about showing y’all around the new digs, but before I begin the tour I first need to thank Programmer Pat for designing and creating this entire site from scratch. The StockMarketCookBook.com would simply not exist if it wasn’t for his considerable skill and expertise in putting it together. On top of that, he is also responsible for creating the SMC Analyzer which I’ll discuss shortly. Words cannot adequately express how deeply grateful I am for all of his efforts. Thank you, Pat!

Okay. Now we can begin the tour. Uh, don’t forget to wipe your feet on the welcome mat!

The Home Page
The main page is divided into three sections. On the right side of the page you’ll see a panel showing the current state of the market. Run your cursor over the Dow, Nasdaq, or S&P 500 headers and you’ll see the corresponding intra-day chart. Below the chart is a ticker of the thirty Dow Industrial stocks (we’ll see how long GM lasts on that list) followed by the top financial headlines. (Click on any headline to show the complete story.) Note that all of the above resources are updated every five minutes. Beneath the headlines box are a list of resources and blog archives.

The center of the page is the blog itself. To see more blog entries or if you want to leave a comment, click on the “Leave a comment or view previous posts” link at the bottom and you’ll be redirected to the blog section.

The left side of the page is where you’ll find a list of our products which include investment strategies or “recipes,” and a portfolio analyzer. As much as Dr. Kris loves researching her articles and sharing her financial knowledge, she’s also interested in getting compensated for her hard work. The good news is that she’s sprucing up her recipes and adding more content to them—hey, for the price of a couple of frappucinos, you can have your own Calendar Call Cake and eat it, too! For now, only four out of the seventeen listed recipes are available but more will be rolled-out shortly.

The other product is the one I’m most excited about—the SMC Analyzer. We’ll be talking more about it over the next couple of weeks. Briefly, it’s a powerful tool that combines market timing with modern portfolio theory—something that I don’t think has ever been done before, and believe me, it wasn’t an easy task! What the analyzer tells you is how much of your portfolio you should allocate to specific asset classes to attain your desired level of return. The beauty of this system is that you only need to rebalance your portfolio once a month at most. This system is far superior to the old buy-and-hold strategy as substantially greater returns can be realized while assuming the same risk. The Analyzer is a tool for investors, not day-traders. It’s particularly useful in managing retirement accounts. Professional money managers will also find this to be an indispensable tool in portfolio balancing.

The SMC Analyzer is a powerful product, but not everyone will find a need to utilize all of the features. With that in mind, we created two versions: a professional version that includes all of the bells and whistles, and a pared down personal version that is easier to use while still giving accurate results. For a more detailed description, click on the Features Tour or click on the Analyzer Demo and check it out for yourself.

Well, that’s it for now. Hope you enjoy the new site. It’s still a work in progress and if you have any technical problems, questions, or comments, we’d appreciate your feedback. You can write us at either of the following addresses:
support@stockmarketcookbook.com
drkris@stockmarketcookbook.com

Tomorrow we return to our regularly scheduled programming. Stay tuned!

**** FOR IMMEDIATE RELEASE ****

Dr. Kris, the founder of the financial blog StockMarketCookBook, today announced that her blog will be moving to her new website this coming Monday, May 11th. Besides her (almost) daily insights into current market trends, she will be introducing new and exciting financial products designed for both personal and professional use. More information on these will be provided as Monday approaches…