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synthetic loan


ERICOPOLY
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Has anyone a word of wisdom regarding synthetic loans?

 

Example:

1)  Write a deep-in-the money put for $30 in proceeds

2)  Buy an at-the-money put for $3 to hedge out all risk

 

You effectively have a $27 loan.  The worst case cost of the loan is the $3 of hedging -- think of this as your interest rate.  You could find yourself being PAID for the loan -- this will happen if the underlying security appreciates more than $3.  If the underlying security appreciates by $30 for example, you are actually being gifted your loan by the market.

 

Of course, if you get assigned you'll need to dump the shares and write deep puts again (not really that big of a deal).

 

 

 

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looking at that as a kind of loan is dicey : you're essentially betting that the price of the security  goes up. you stand to gain a max of 27 if it does, or if it goes down, you stand to lose a max of 3, the amount of the time premium on that 3 atm protective put. and thats assuming you dont get exercised and have the stock put to you....BIG IF on a put so deep in the money that there is essentially no time premium as per your theoretical example. its a potentially costly prospect too ...the transaction costs & the bid/ask spreads on options can be nasty if you need to keep rolling them over or swapping the stock assigned you for more deep itm put writes. especially on longer term options or LEAPS where the higher option prices carry wider spreads & less liquidity than the front months.

You effectively have a $27 loan.  The worst case cost of the loan is the $3 of hedging -- think of this as your interest rate.  You could find yourself being PAID for the loan

 

not quite. you'll be paying margin interest rates on your "loan" & only collecting a paltry money market rate on the 27 proceeds. where ever margin rates stand currently, thats sure to be a costly negative spread. add in the theta or the cost of the time decay on your atm 3 put & things get even more costly if the stock doesnt move enough quickly in your favor.

 

and, besides, in the shorter run stock prices are kind of a random walk. so you'd be rolling the dice unless you were dealing with LEAPS at least a year out. and if you're confident about the stock why not just buy a LEAP or the stock itself?

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The margin interest rate only gets triggered if you actually get assigned.

 

yes, assuming he has the cash to cover the sale of the put...i suppose i should have assumed he did.

 

but that 3 atm purchase of the protective put, assuming its 100% time premium, still equates to an 11% annualized interest cost on the $27 of proceeds rec'd if its 1 year out...1% money market rates on $27 earnes him 27 cents during the same time. $3 - .27 still equates to $2.73 cost, or 10% annualized.

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Ericopoly,

 

Since you call it a loan, I am assuming that you want to take the $27 in net proceeds and do something with it, like buying a home, business or other securities.

 

If that is the case, then the cash is no longer in the account to buy back your put and you will face a steep margin requirement on such deep in the money put. You could eventually risk a margin call if your collateral or other securities in your account decline quite a bit in value.

 

It is an interesting strategy, but I guess that you don't want to go over board with it.

 

Cardboard 

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The margin interest rate only gets triggered if you actually get assigned.

 

yes, assuming he has the cash to cover the sale of the put...i suppose i should have assumed he did.

 

The way that works is that writing naked puts to leverage the account eats into the accounts' margin borrowing power but does not actually amount to a margin loan, since the market is loaning you the money instead of your borrowing it from your broker.

 

 

So lets say you start with one share of Berkshire in the margin account valued at $122,000 and no cash.  You then write 10 contracts of a $40 strike put on Wells Fargo for $11.75.  The account will now be leveraged but you are paying no margin interest because instead of the leverage costing you cash, it actually added $11,750 in cash to the account.  You can then withdraw that $11,750 in cash and you still won't be paying margin interest.

 

But you do have the margin buying power of the account eroded, and it is of course riskier because your broker can still get nervous and force a sale at distress prices in a meltdown.  So, I was suggesting to hedge the additional WFC that you added exposure to with an at-the-money put.  

 

Cardboard is right though that it does put pressure on the overall margin risk of the account.  And I am thinking of ways of financing a house.  Like most people here, we've been through a "bumpy" stock market the past 10 years and I am looking at that carefully.  At the same time, I don't want to sell my shares right now either.

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Ericopoly,

 

Last year, I was doing this with both puts and calls.  It worked out fine, but what I didn't like was how much I had to be

on it to deal with the assignments.  It wasn't too big of a deal, but when I was traveling or out of contact, I felt too

exposed.  I doubt I will do it again.

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