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Synthetic Stock Positions Within Registered Accounts

Richard Croft
February 6, 2017
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Synthetic Stock Positions Within Registered Accounts

As the name suggests, a synthetic stock position is equivalent to a long stock position. Similar risk reward parameters but with some structural advantages for investors who want to utilize the strategy within registered accounts.

 

In this column, we will focus on Canadian bank stocks. What else is new! Like it or not banks are in a sweet spot. Expect higher interest rates which improves margins and if we get a stronger Canadian economy, more loans.  De-regulation is also a possibility which will have the greatest benefit for Canadian banks who do business in the US. That said, I am not suggesting these positions with de-regulation in mind.

 

At the end of trading last week, Royal Bank (TMX: RY) was at $94.60. The January 94 calls were bid $5.00, offered at $6.15. The January 94 puts were bid $5.70 offered at $7.15. I know these spreads are wide enough to drive a truck through. For purposes of this discussion I will assume you can buy the calls at $5.50 and sell the puts for $6.40 for a net credit of $1.10 which is substantially less than the $3.32 in dividends Royal Bank will pay between now and next January. Anything less than that and I would not do the trade.

 

To create the synthetic long position one simply buys the January 94 calls and sells the January 94 puts. The breakeven price for the synthetic stock position is $92.10 ($94 strike price less $1.10 net credit = $92.10). Any price above $92.10 at the January expiration is profitable, below $92.10 unprofitable.  That’s roughly equivalent to the profit and loss parameters one would get holding RY at $94.60, although to be fair, accounting for the $3.32 in dividends would reduce the out-of-pocket cost base on a long stock position to $91.28 per share.

 

The synthetic position presumably accounts for the dividends in the option pricing model which is why the option prices quoted earlier should reflect a reasonable alternative to the long stock position.

 

The obvious question is why engage in two trades when a simple purchase order for the shares accomplishes the same thing. To that point there are a couple of responses. The synthetic stock position creates a credit in your account. Rather than deploying capital to buy shares the synthetic position – specifically the short put option – creates an obligation to buy shares at $94 through January 2018.

 

Other considerations include tax. The option positions yield capital gains – or losses – versus gains (or losses) plus dividends for the long stock position. Relative to dividends, capital gains receive preferential tax treatment.

 

Keeping with the tax theme investors might be able to apply some interesting tax strategies when executing synthetic positions. For example, the sale of puts or uncovered calls inside registered plans is not allowed. However, one can buy calls inside RRSPs, RRIFs and TFSAs. With that in mind, investors could buy the calls inside a registered account while writing the puts in a non-registered account. Clients will pay tax on any gain when the short put position is closed but will have unlimited zero tax upside on the long call.

 

Now that we have a rudimentary understanding of the strategy let’s consider the merits of an investment in Canadian banks. The value proposition for Canadian banks begins with Trump’s version of an alternative universe.

 

In his quest to make “America Great Again” Trump has laid out a business-friendly agenda that should benefit most segments of the economy. The chief beneficiary being the financial sector which in my mind, enjoys the most powerful tail winds in more than five decades. My thesis assumes that Canada will gain more from a rising US economy than it will lose on any re-negotiation of NAFTA. That’s a big assumption but one that seems to have held sway in the currency markets. Note that the Canadian dollar is one of only a handful of currencies to have held it own against the greenback since Trump was elected.

 

The regulatory environment has been a major headwind for US banks. Less so for Canadian banks that weathered the financial crisis better than most other geographic regions. But lifting some of the restrictions on US banks will ultimately benefit the US economy and provide additional benefits to banks doing business south of the border. Toronto Dominion, Royal Bank of Canada and Bank of Montreal all fit within this thesis.

 

Another concern for Canadian banks is that Canadians are over-leveraged. That could cause problems. However, that will be muted if the economy strengthens as I think it will. If housing remains stable Canadians will benefit from the wealth affect of higher home values.

 

Although not guaranteed, I think Canadian interest rates will rise in tandem with US rates. What is more important is how rising rates affect the yield curve. If the short end rises but long rates remain the same, we would see a flattening of the yield curve. That’s not good because banks typically borrow short and loan long. So far that has not been a problem but it is something to keep in mind.

 

A normal yield curve in a rising rate environment is good for the margins on all the Canadian banks. Whether they have a major presence in the US or not. Rising rates, expanding margins, increased borrowing and potential de-regulation will prove to be powerful tailwinds which should provide a significant boost to bottom lines.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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