No need for the Real Thing.
byTraderPlus Editor— ISSUE 7 — NOV/DEC 2011
If you can access the same benefits, is it worth paying more? By Wai-Yee Chen
In many cases, synthetics are just as good as the ‘real’ thing. The real thing usually costs more, often, many times more. For the owner, the satisfaction of owning the real thing is derived from their own personal knowledge, though others may not care.
Synthetics on the other hand, can often get the job done just as well. Not only that, good synthetics can be strong replicas of the real thing and look good too. More importantly, synthetics are likely to give the holder a higher level of satisfaction as it costs less – and therefore there is less to lose.
In the current volatile climate, many investors have chosen to sit on the sideline with cash to wait it out before returning to buying shares. Others are holding on to their shares to ride out the storm.
Regardless which segment you are in, the reality is, there is no need to own the real thing (that is, the fully paid shares) when you can get their replicas through owning the synthetics. Some who hold shares might argue that the “real thing” gives them the income that they need from dividends and franking credits. Consider this: what if a share has just paid dividend and is not expected to do so again in six months, and on top of that has the possibility of depreciating in value in the next six months? Why not consider cashing in the real thing and then spend just a fraction to get its replica?
If this idea appeals to you, let’s look at ANZ shares, which are trading at about $20.50. If you were holding 1,000 of ANZ, you would have just received $760 worth of dividend. In order to sit on the shares and wait for another six months before being paid again, the shareholder can swap the “real thing” for its synthetics. The shareholder has the benefits of releasing the cash from his shares, having less at risk and yet is still able to benefit from any appreciation in its share price or jump back into the stock.
An ANZ shareholder is considering freeing up cash for a nine month period, which he sees as a volatile period in the stock market. He is looking to swap his shares for this synthetic – buying a nine-month ANZ call option at the strike of $20.50. This option is costing about $2.00, therefore for a 1,000 underlying exposure the investor would be buying 10 contracts or spending about $2,000 for this Synthetic.
This is how it will work out for this ANZ shareholder: Should ANZ fall, he would lose a maximum of $2,000. Should ANZ rise, he is still able to benefit from the rise in the $20.50 call option he bought. Meanwhile, he has released $18,500 from his holding of 1,000 ANZ shares. Knowing the maximum amount he can lose from the synthetic gives this shareholder a peace of mind and sense of control over his investments that he can’t get from owning the shares. He is now sitting on cash and yet not losing out on any potential recovery in the stock market. The benefits of the synthetic are not just financial, but emotional as well.
The Synthetic releases cash, quantified a maximum potential loss, limits downside to a minimal amount; yet at the same time allows room for any upside. Contrasting these benefits to the holding of underlying shares, which subject the holder to the risk of large capital losses (even for the benefit of receiving some dividend income) and exposes the shareholder to the mercy of the volatility of the market, where much of the discomforts lie.
The strength of the synthetic lies in its flexibility as well. One can have varieties with their replicas.
The basic long call (buying) synthetic above can be supplemented with another option. In order to put even less at risk or spend less on the long call synthetic, the investor can sell put options. The nine-month $20.50 call option bought can be matched with the selling of a nine-month put. This is likely to reduce the cost to zero or even generate positive income potentially (depending on the choice of strike). A lower strike on the put generates less income, but has less risk too. A long call/short put synthetic gives the investor the potential of getting back into the ANZ without paying for it now.
With so much flexibility and benefits using synthetics, why would you own the real thing.
Wai-Yee Chen of RBS Morgans has been advising in options for fifteen years and is the author of ‘OptionsWise how to invest sensibly’ (www.optionswise.com.au). Wai-Yee regularly shares her unique options insights on CNBC and SKY and contributes regularly to Trader Plus, Wealth Creator and YourTradingEdge amongst others. Contact: firstname.lastname@example.org