Wednesday, June 14th, 2017

Leveraging Options With Bonds?

I am interested in investing in some options (to buy or sell) and I wondered if my hypothetical strategy makes sense. . . do it to me. So the most you can lose a call or put option is the amount initially cost options, so this is what will determine how much risk I’m willing to bear. To defend against this potential loss, I would invest in bonds when the total return is less than the amount you could lose in the options. Since dividends on the bonds are very reliable, I have successfully harnessed the options. I’m also assuming that the bonds be held until maturity, so do not have to worry about interest rate risk (if not the change in the market I am also assuming the bonds are not required). In conclusion: there is virtually no money you can lose in the long term and have much to gain. Does my theory make sense?

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3 Responses to “Leveraging Options With Bonds?”
  1. Jerry says:

    Buying the bonds means investing more money. That does not leverage options in any way.

    You have a problem of matching the maturity of the bonds with the expiration of the options. If the bonds are long term, you have a timing mismatch. If the bonds are short term (T-bills), rates are so low that the interest would not allow you to buy a meaningful options position.

    Either you accept risk of loss, or the timing mismatch leaves you long bonds with inflation risk to purchasing power. So no free lunch.

  2. zman492 says:

    I fully support everything Jerry said. I just want to add a couple of more points.

    You said “There is virtually no money i can lose in the long-run” which just is not true.

    First, you are assuming the issuer of the bonds will not default. While it is unlikely, unless the bonds are guaranteed by the United States government there is a very real chance of default.

    Second, consider the person who buys bonds and every time he receives an interest payment from the bond he uses it to buy options. It would be difficult to argue that he cannot lose any money since he is buying options which may become worthless with money out of his account. The money he can lose is exactly the same as if he bought the same options with money he made digging ditches. The only difference is the source of the money. If he buys $500 worth of options that expire worthless he will have $500 less than if he had not bought the options, regardless of the source of the money.

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    I also want to expand a bit on what Jerry called a “timing mismatch” which will occur if the options do not expire at the same time the bonds mature. If you bought bonds that mature in five year and bought options that expire in six months, thing of your situation after the options expire in six months. If interest rates have gone up significantly, the value of your bonds will probably have decreased. In that case you will have a realized loss on the options that expired, an unrealized loss on the bonds you hold, and a gain on the interest you received. If you assume the interest received cancels out the loss on the options, that leaves you with an unrealized loss on the bonds. Your net worth will be down by the amount you have lost on the bonds. If you want to sell the bonds for any reason, such as having a better use for the money, you will have a realized loss. The fact that you expect to be able to make back that loss by holding the bonds another four and a half years does not mean you do not have a loss after six months.

    —–

    I also want to mention that the current “risk free” interest rate is part of the calculation used in determining the price of an option. If interest rates go up you will, in general, find options more expensive. If you have a fixed amount you can use to buy options, which in your strategy you do, that means you will be able to buy fewer options, reducing your potential profit.

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    Finally, I am not sure you understand what is meant by leveraging and how it works. Even if you do, I will explain in case someone else reading this answer does not.

    Leveraging means increasing the percent gain or loss made when a price changes. For example, assume a stock is trading at $60 and it has $60 call options that expire in 1 year available for $3 per share. Also assume there is a high quality bond available that expires in one year and has a yield to maturity of 3%.

    Now assume that three people made investments. One person simply bought the stock. The second person just bought the call option. The third person bought the bond and used the projected profit from the bond to buy the option.

    If the stock was $69 one year later:

    The first person would have a gain of $9 for each $60 invested, making his profit 15%.

    The option would be worth $9, so the second person would have a gain of $6 for every $3 invested, making his profit 200%.

    The third person bought $100 worth for the bonds for every $3 he investing in the options, making his total cost $103 for every option. In a year he would have received $103 per option from the bonds plus $9 for the option, for a total of $112. That would make his gain $9 for every $103 invested, a little less than 9%.

    Clearly the person who bought just the call option got a lot of leverage because his got a 200% profit instead of a 15% profit. The person who bought the bond plus the call option did not get any leverage since he made a smaller percentage.

  3. James says:

    OK, basically what I want to say is, in order to avoid ALL the problems the above answerers have mentioned and still do what you suggested using bond yields to cover the cost of options, simply buy call options with the quarterly earnings from your bonds and then hold your bonds to maturity to prevent capital risk. That way, you will be ensured risk free trading of call options (if you don’t factor in the loss of risk free interest or other opportunity costs arising from the lack of use of the money as risk).

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