A Bad Deal?

I was looking at investments offered in my offshore account and came across the following structure:

  • 5 year investment into china fund
  • capital preservation (built-in floor at initial investment level)
  • max 55% return total across 5 years, the bank pockets the excess above

For someone not in the financial business this may seem to be a good deal (seeing the 55% and capital preservation). I think it is a relatively poor deal though. The continuously compounded effective annual rate is only ~8% and that is only achieved if the market does indeed appreciate 55%.

I began thinking about how closely could replicate this structure on my own, but with a much higher max payoff. Though the payoff function I am going to indicate is not perfect (I can go under my initial capital if the timing of my protection is not right), would do as follows:

Initially

  • buy into FXI index
  • allow some appreciation and then buy the 1 month put option at the initial point of entry

On an ongoing basis:

  • roll put option at initial investment point + cost of option premiums thus far, maybe with longer maturity
  • if FXI drops below initial investment, sell FXI, sell option, coverage should be close to offsetting
  • as and if FXI approaches entry point buy in again and buy protection
  • repeat

Of course one can structure this more advantageously:

  • additional protection (by adjusting strike upwards as FXI gains)
  • reentering trade if FXI falls at lower level rather than initial investment level

The cost of the options is paid for out of the returns or in the worst case through the adjusted strike price. That said, increasingly, the options are going to be deeper and deeper out of the money if FXI continues to be a good investment (meaning cheaper hedging costs).

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4 Comments

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4 responses to “A Bad Deal?

  1. Chronos Phenomena

    Well said… Did you try this in practice? It’s more than three years since you talked about it?

    • tr8dr

      I did not try to put it together. I do other model-based trading, so never had the time to properly study it / put it together.

      One of these days when I have time. The concept of principal protected investing is indeed interesting.

  2. Francis

    I am very curious about the approach that you have described here. I am just coming into financial trading as a software developer. I stumbled across your blog from http://howtohft.blogspot.com/

    I have started from the very beginning of your blog posts – so I don’t know what else you have written. But a detailed description of each of the stages of this investment strategy would be very well appreciated.

    How easy would it be to run it through retrospectively – since the market is now known from the time when you posted this? Anyway, I will keep reading.

    • tr8dr

      It’s not nearly as simple as I described it. For one thing you want to time your entry when is in an uptrend and then buy the put. One also can only reasonably do this for an equity with a lot of movement (such as emerging market ones), where the potential appreciation outweights the cost of buying options. The important thing is to get appreciation to the point where buying the options becomes very cheap.

      If you start this at the beginning of a long term up-trend the cost of buying the options becomes increasingly cheaper. For instance, right now, if you purchased EEM at the money would cost you ~1% per month. However if the equity appreciates as it moves away from the original purchase price:

      put strike @ ATM: cost: 1%
      put strike @ -2%: cost: 6/10ths %
      put strike @ -4%: cost: 3/10ths %
      put strike @ -6%: cost: 2/10ths %
      put strike @ -8%: cost: 8/100ths %

      As you can see if you get past some initial appreciation hurdle, the cost / mo scaled across a year becomes inexpensive. Options may be a more expensive way to do this however. Ideally you want to lock in a strip of options at some price when conditions are favorable. Otherwise if the prices of the protected equity comes down, it becomes more expensive to protect.

      If one is set up appropriately it may be cheaper to do one’s own delta hedging with a long / short portfolio and perhaps some deep out-of-the money options for black-swan type events. I have not tested the mechanics of this.

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