Michael Lovelady - Profiting with Synthetic Annuities: Option Strategies to Increase Yield and Control Portfolio Risk

Option Strategies to Increase Yield and Control Portfolio Risk

Michael Lovelady

Vice President, Publisher: Tim Moore
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Manufacturing Buyer: Dan Uhrig

2012 by Michael Lovelady
Pearson Education, Inc.
Publishing as FT Press
Upper Saddle River, New Jersey 07458

This book is sold with the understanding that neither the author nor the publisher is engaged in rendering legal, accounting, or other professional services or advice by publishing this book. Each individual situation is unique. Thus, if legal or financial advice or other expert assistance is required in a specific situation, the services of a competent professional should be sought to ensure that the situation has been evaluated carefully and appropriately. The author and the publisher disclaim any liability, loss, or risk resulting directly or indirectly, from the use or application of any of the contents of this book.

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Company and product names mentioned herein are the trademarks or registered trademarks of their respective owners.

Certain screenshots, including Options Analysis Workspace and Theoretical Positions, were created with TradeStation. TradeStation Technologies, Inc. All rights reserved.

All rights reserved. No part of this book may be reproduced, in any form or by any means, without permission in writing from the publisher.

Printed in the United States of America

First Printing June 2012

ISBN-10: 0-13-292911-2
ISBN-13: 978-0-13-292911-0

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Library of Congress Cataloging-in-Publication Data Lovelady, Michael Lynn, 1957
Profiting with synthetic annuities : option strategies to increase yield and control portfolio risk /
Michael Lynn Lovelady. -- 1st ed.
p. cm. ISBN 978-0-13-292911-0 (hardcover : alk. paper)
1. Options (Finance) 2. Annuities. 3. Risk management. I. Title.
HG6024.A3L68 2012
368.37--dc23
2012009307

I would like to express my sincere gratitude to several people who made this book possible. At Pearson/FT Press, my editor Jim Boyd, who believed in the material and understood better than me what the scope of the book should be; Michael Thomsett, who gave the project invaluable guidance and direction from beginning to end; Lori Lyons, for her dedicated and patient production management; Krista Hansing, for copyedits; and all those who helped with marketing, illustration, and production.

I would also like to thank Don DePamphilis at Loyola Marymount University for giving me the idea to write the book and being a mentor; Cooper Stinson, a gifted writer who reviewed early manuscripts and asked all the right questions; Leslie Soo Hoo, for much needed help in reading and revising drafts; and Abbie Reaves, for editing. Also, my friends and family who gave me encouragement and inspiration, and forgave me for missing tee times: my parents, Abigail, Alice, Billie, Brennan, Colby, Connor, Ethan, Eva, Frank, Hannah, Joanna, Lindsey, Matty, Noah, Nolan, Petra, Sally, Steve-O, and Tony.

Above all, for life itself, the Triune God of CreationI always remember.

Michael Lovelady, CFA, ASA, EA, is the investment strategist and portfolio manager for Oceans 4 Capital Group LLC. Michael designs and implements reduced-volatility and theta-generating hedge fund investment strategies. He developed the synthetic annuity (SynA) and uses it extensively in portfolio management.

Prior to founding Oceans 4, Michael worked as a consulting actuary for Towers Watson and PricewaterhouseCoopers. Much of his work was related to design issues at a time when many employers were moving away from traditional defined benefit plans. Michael worked with clients to consider and implement alternatives ranging from defined contribution to hybrid DB/DC plans. His experience with retirement income strategies, from both the liability and asset sides, has given him a unique perspective.

Michael has also been involved in teaching and creating new methods for making quantitative investing more accessible to students, trustees, and others without math or finance backgrounds. He developed the investment profilea graphical representation of investments and the basis of a simplified option pricing model, and visually intuitive presentations of structured securities.

Michael has served various organizations, including Hughes Aircraft, Boeing, Global Santa Fe, Dresser Industries, the Screen Actors Guild, The Walt Disney Company, Hilton Hotels, CSC, and the Depository Trust Company. He is a CFA charterholder, an Associate of the Society of Actuaries, and an ERISA Enrolled Actuary. He currently lives in Los Angeles.

Profiting with Synthetic Annuities is about the use of options in investing and portfolio management. This book is written for experienced investors who are considering option strategies, for experienced option traders, and for institutional investors interested in alternative strategies.

Synthetic annuities are structured securities that use options and management rules to customize the risk/return profile of investments. Options are used to create a synthetic risk-smoothing mechanism and annuity-like cash flows. The management rules are designed to mitigate risk and maximize income over the long term. Together, the options structure and management rules address several emerging issues in investment management:

The explicit use of hedging, insurance, and risk allocations in risk management instead of reliance on traditional portfolio models

The desire for greater yields not related to market direction

A recognition of behavioral influences on investor performance

The growing importance of volatility-reducing quantitative methods, particularly those related to stock options

The desire of many investors for annuity-like income streams.

Unlike many books on options and options strategies that deal mainly with tactical trading, Profiting with Synthetic Annuities is about the strategic use of options as integral components of investment portfolios. Synthetic annuities treat options as permanent components of an investment position. The goal is to create a hybrid architecture that balances the long-term investor perspective of mean-variance portfolios and the risk discipline of quantitative-based strategies.

In terms of presentation, Profiting with Synthetic Annuities uses a unique visual representation of structured securities. As a result, few formulas appear in the book; instead, graphical interpretations communicate the ideas and compare alternative investments.

If you Google the term synthetic annuity, you wont find much. There is a reference to an obscure tax issue, as well as an article about design projects by several investment firms and insurers who believe the next Holy Grail is an annuity-like product for 401(k) plans that allows participants to convert highly volatile assets into defined benefit type payments.