Combining bonds and stocks to take advantage of capital market returns
The objective of every person who invests in the financial markets is to achieve the best returns for the investment of their money, this is the reason why intermediaries, issuers and stock exchanges or derivatives, design new products every day. to maximize the profits of these investors, providing them with the necessary information to understand the risks and returns associated with each instrument or portfolio.
The process of involving shares of listed companies, more complex to value, to the investment portfolios of those people who traditionally invest in debt bonds with predetermined returns and associated with much lower risks, is very slow and involves a learning period. by investors on the characteristics of the instruments in the capital markets.
A process that, when involving derivative products such as futures and options, becomes more complicated by requiring more qualified investors to be able to carry out their valuation and measure their risk exposure by these contracts.
These are some reasons why operators and intermediaries have created investment strategies such as the “90/10” strategy, which involves placing 10% of their investment funds in long call options and the remaining 90% in a money or debt table instrument (in our examples we use CETES) that are held until the option expires, these types of portfolios allow investors to feel much more comfortable and be willing to use that small percentage in derivatives, such as the options, reducing their concern about not knowing how they work or their valuation.
It is very important to identify that international operators carry out this strategy when they expect interesting returns from the capital market in the medium term, seeking to involve investors who traditionally do not buy stocks or derivatives.
This strategy provides both leverage (of options) and limited risk (of CETES), allowing the investor to receive benefits from a favorable movement in the price of capital market shares, while limiting the risk of falling premiums., of the purchase option, less any interest received by the treasury certificates.
Example:
Assume that CEMEX CPO series is listed at $ 60 pesos per share on the Mexican Stock Exchange. To purchase 100 shares of CEMEX CPO, an investment of $ 6,000 pesos in shares is required, which in its entirety would be exposed to all the risks associated with the capital markets. To apply the 90/10 strategy, you would purchase a CEMEX CPO “At the money” purchase option on the Chicago Board Options Exchange (CBOE), with an exercise price of $ 60 pesos and a term of six months. Assuming a premium of $ 6 pesos per share covered by the options contract, so the total cost of the option would be $ 600 pesos.
This purchase leaves you with $ 5,400 pesos available to invest in CETES for six months. Assuming a 10% rate of return and that the treasury certificates are kept until maturity, the $ 5,400 pesos would accrue interest for $ 270 pesos during the six-month period.
The accrued interest would effectively reduce the cost of the option to $ 330 pesos (premium of $ 600 pesos less interest of $ 270 pesos).
If the CEMEX CPO price increases on the Mexican Stock Exchange more than $ 3.30 pesos per share, your Long Call option would liquidate the appreciation in pesos on the expiration date of a long position in 100 CEMEX CPO shares, but with less capital invested. in the option, that the one that had been invested in the 100 shares of a security in the capital market.
If instead the price of the security increases less than $ 3.30 pesos or its price falls, your loss would be limited to the price you paid for the option ($ 600 pesos) and this loss will at least be partially offset by the interest paid by Banco de México for the CETES, plus the premium you receive when closing your position selling the option in the CBOE secondary market, if you so choose.
- Scenario 1:
If the price of the CEMEX CPO share, on the Mexican Stock Exchange, increases to $ 65 pesos per share (8.33%) in six months and the amount of the premium of our “In the money” option, that is, the price The one that can be sold in the CBOE secondary market increases to $ 8 pesos, the result of the position is:
Sale of the CEMEX CPO Option in the CBOE secondary ……… $ 800.00
Interest received by the Holding of CETES by Banco de México ………. $ 270.00
Less the initial cost of the CEMEX CPO option ………. - $ 600.00
UTILITY………. $ 470.00
As we can see, using 10% of our investment funds available in CEMEX CPO options and meeting our expectations for growth in capital market shares in the medium term (8.33%), has resulted in a profit of $ 200.00 additional pesos to the investor, who have gone from 10% annualized return on their capital invested in CETES by 90% of their invested funds, to 15.67% annually when using this strategy with only 10% in Call options.
- Scenario 2:
If the share price of CEMEX CPO, on the Mexican Stock Exchange, decreases to $ 55 pesos per share (- 8.33%) in six months and the amount of the premium for our “Out the money” option, that is, the price at which it can be sold in the CBOE secondary market, decreases to $ 4 pesos, the result of the position is:
Sale of the CEMEX CPO Option in the CBOE secondary ………. $ 400.00
Interest received by the Holding of CETES by Banco de México ………. $ 270.00
Minus the initial cost of the CEMEX CPO option ……… - $ 600.00
UTILITY………. $ 70.00
As we can see, when our expectations on capital market prices were not met, the losses caused by the decrease in the price of option premiums from $ 6 to $ 4 pesos, is offset by the returns generated by CETES, resulting in a small profit for the investor of $ 70.00 pesos or 2.33% annualized.
This is one of the multiple strategies with derivatives, and especially, with options that can be carried out; I invite you to learn about this class of derivative instruments and above all to use them as an efficient mechanism for risk management or profit maximization.
