A synthetic stock position is equivalent to a long stock position. It carries similar risk/reward parameters, but with some tax advantages for clients who trade U.S. securities. On that point, we will look at an example of creating a synthetic stock position in Bank of America (NYSE: BAC). (Full disclosure: this strategy is held by me in my personal accounts.)
At the time of writing, BAC was trading at $22.70. (All prices quoted in U.S. dollars.) Looking at January 2018 options, the following prices exist: BAC January (2018) 25 calls at $1.70 per share and BAC January (2018) 25 puts at $4.00 per share.
To create the equivalent of a long stock position, the investor would purchase the January 25 call and sell the January 25 put: this would result in a $2.30 per share net credit. The break-even price for the synthetic stock position is $22.70 ($25 strike price minus $2.30 net credit = $22.70). Any price above $22.70 is profitable. Below $22.70 is unprofitable. These are exactly the profit-and-loss parameters you would get when holding BAC at $22.70 per share.
The obvious question: why engage in two trades when a simple purchase order for the shares accomplishes the same thing? There are a couple of responses.
The synthetic stock position creates a credit in the client’s account. Rather than deploying capital to buy shares, the synthetic position – specifically, the short put option – creates an obligation to buy shares at $25 through January 2018. The synthetic position generates a net credit, which eliminates the need to convert loonies into U.S. dollars at the current exchange rate.
Other considerations include taxes. Canadians buying U.S. securities in a non-registered account are saddled with withholding taxes on dividends, which are ultimately taxed as ordinary income in Canada. The Canadian dividend tax credit does not apply to income from foreign securities.
The synthetic position accounts for dividends in the option pricing model, but without any tax considerations: clients are still exposed to capital gains and losses. In my view, Canadian investors should never buy high dividend-paying U.S. stocks in non-registered accounts.
A new world for banks
Staying with the tax theme, your clients 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, you can buy calls inside RRSPs, registered retirement income funds and tax-free savings accounts. One approach clients might consider is buying the calls inside a registered account, then writing the puts in a non-registered account. The Client pays taxes on any gain when the short put position is closed, but will have zero taxes upside on the long call.
Now, let’s consider the merits of an investment in BAC. In President Trump’s quest to “Make America Great Again,” he laid out a business-friendly agenda that should benefit most segments of the economy. The chief beneficiary is likely to be the financial sector, which, in my mind, now enjoys the most powerful tailwinds seen in more than five decades.
U.S.-based banks seem to be out of the political penalty box (save for Wells Fargo & Co.), having closed the book on major litigation headwinds. To underscore the importance of this: BAC spent more than $180 billion over six years to settle claims from bad mortgages.
The regulatory environment also was a major consideration: the aftermath of mortgage defaults meant that fewer than 50% of American consumers had credit scores that made them creditworthy. Little wonder that so little of the capital created under quantitative easing (QE) found its way to Main Street. Most of that QE money simply sat within the banking system, providing no stimulus.
On the positive side, the savings rate rose to 7%, compared with the negative 2% rate prior to the global financial crisis of 2008-09. Longer term, this change is positive, but it also slowed growth. Surviving the litigation nightmare and restructuring compliance has positioned money-centre U.S. banks to ramp up their lending departments.
At the same time, credit scores have improved and U.S. real estate prices have stabilized. (BAC is the second-largest mortgage originator in the U.S.) Those twin scenarios have increased the number of potential borrowers. The latest lending data make the point: in the fourth quarter of 2016, big banks were lending at a pace similar to loan volumes prior to the crisis.
When you consider the improved state of borrowers and the fact that banks are sitting on roughly $2.5 trillion in excess reserves – which translates into roughly $50 trillion in potential economic activity – the runway for new loans is long. We are probably sitting at the beginning of this runway.
That leads to bank profits for 2017. We are seeing a rising interest rate environment across all segments of the yield curve. That’s important because there was some fear that we could see a flat yield curve or, worse, an inverted yield curve. In either of these scenarios, higher rates do nothing for institutions that traditionally borrow short term and lend long term. But with a normal yield curve – a rising slope from left to right (left representing the shortest maturities) – bank profit margins will expand. Generally, a 1% rise in interest rates provides a 15% bump in margins.
In summary, improved profit margins, increased loan demand, excess reserves available for new loans, less rigid regulation and less litigation expense all bode well for the U.S. money-centre banks.
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