Is It Possible To Make Money With No Risk?
Is it possible to participate in the upside of a long term bull market while having absolutely no risk to the downside? Why yes, it is possible. In fact, not only is it possible, but the product that makes this possible happens to be one of the more popular investment vehicles pushed by brokerage houses across the country.
Although each brokerage house calls it something different, these instruments are universally called Equity Linked Notes or ELN’s. Lehman Brothers calls them SUNS (Stock Upside Notes). Merrill calls them MITTS (Market Index Target Term Securities). Salomon Smith Barney has ELKS (Equity Linked Securities). Goldman uses the term SIGN (Stock Index Growth Notes). And last but certainly not least, UBS has SIRS (Stock Index Return Securities).
So what exactly are these magical investment vehicles? Well the brokerage industry needed to create new products after many people left the big wire houses for smaller do it yourself shops. And even many turned to Direct Access Brokers where they could actively invest and trade their account for minimal commissions. So in order to lure the public back in, these magical investment vehicles were created.
What they are is a combined fixed income and equity product. They offer a guaranteed return of your initial capital no matter what happens in the market. And if the market roars higher, you get to participate in most of the upside. Of course your broker will charge you a hefty fee for this service. On top of the 2% he gets for managing your account, there are usually sales fees on top of that and in some cases maintenance fees as well. Not to mention you have to pay taxes on what you do make. And to top it off, the investment firm even takes a small slice of the profits. They usually set a level in the index where you start making money. Of course they earn the spread between the current level and that high water mark.
So are these things really worth it? The answer is maybe, but certainly not with all the fees and taxes you have to pay to your broker. Being that the Chicago Options Traders group is full of very intelligent people and are very resourceful, we can make these things ourselves without all the added fees and to top it off, do it in a way in which we don’t even have to pay taxes on it.
So how do we do this? Well first of all, let’s reveal the secrets of what this really is. The first thing you do is buy a zero coupon bond. You can buy these in increments of anywhere from one year to 30 years with 10 years being the most common. A zero coupon bond is just that, it has no coupon attached to it. So you do not receive an interest payment every 6 or 12 months like you normally would if a coupon was attached. Instead the bond is sold at a discount to the future value of that bond. Then at maturity, the bond will be worth par.
One thing to remember is even though you don’t actually receive an interest payment, you will have to pay taxes on the imaginary interest each year. Unless of course, you do one of two things, execute this trade in an IRA account or a 401k plan or buy zero coupon municipal bonds, most of which are exempt from both federal and state income taxes.
So now we removed the tax element and the fee element. Now let’s add the second ingredient. That is instrument you want to participate in the upside in. It might be an index like the SP 500, or the QQQQ index. Or it might be an individual equity or possibly a group of equities. Perhaps create a power index with the likes of GOOG, EBAY, AAPL, TASR, and SIRI. You can do whatever you want, that is the beauty of it. Then what you do is buy long term leap call options in the index or stocks. Say you choose the SP 500. You might want to buy the JAN 07 ATM leaps or perhaps buy the ITM leaps to be a little more conservative. Where are we getting this money you ask? From the discount on the zero coupon municipal bond we purchased. Let’s say we buy a 20 year zero coupon municipal bond for $20,000. This bond may cost us $6,757. That would represent a yield of 5.5% a year and the tax equivalent yield could be as high as 7.5% So now we take the difference between $20,000 and $6,757 which is $13,243 and invest it in our long call leap options. If we buy the Jan 2007 calls we will have to roll them over then and perhaps buy the Jan 2010’s and so on.
The idea is, if the market trades higher over that period, you sell the leaps for a profit and then roll them to the next contract and keep doing this until the 20 years are up. One of two things will happen. If the market traded higher, you will have earned a nice return on your long SP 500 trade plus you will have the full maturity of your $20,000 bond. If the market crashes or goes no where over that 20 year period, you will have 100% of your capital returned to you when the zero coupon bond matures.
Of course technically in this example, you will have lost some money in opportunity cost. Had you placed the $20,000 in a treasury security, you could have earned the yield on that bond over the 20 years. But if the bull market continues to push forward over the next 20 years, your long call leap options will most definitely outperform any fixed income product and most equity products as well. And the best part about it, you do this with no fees on your total assets and you did this tax free. Of course you will have small commissions to pay every three years or so but it will not be 2% of your assets.
So there you have it. Now with all the money you are making trading options, you can siphon some money away in a retirement account and let it grow without the risk of blowing your retirement. Not that it would happen to any of the members of the Chicago Options Traders Group. Of course this goes without saying, but this post is in no way a recommendation for investment nor am I giving financial advice in any way.
John
Although each brokerage house calls it something different, these instruments are universally called Equity Linked Notes or ELN’s. Lehman Brothers calls them SUNS (Stock Upside Notes). Merrill calls them MITTS (Market Index Target Term Securities). Salomon Smith Barney has ELKS (Equity Linked Securities). Goldman uses the term SIGN (Stock Index Growth Notes). And last but certainly not least, UBS has SIRS (Stock Index Return Securities).
So what exactly are these magical investment vehicles? Well the brokerage industry needed to create new products after many people left the big wire houses for smaller do it yourself shops. And even many turned to Direct Access Brokers where they could actively invest and trade their account for minimal commissions. So in order to lure the public back in, these magical investment vehicles were created.
What they are is a combined fixed income and equity product. They offer a guaranteed return of your initial capital no matter what happens in the market. And if the market roars higher, you get to participate in most of the upside. Of course your broker will charge you a hefty fee for this service. On top of the 2% he gets for managing your account, there are usually sales fees on top of that and in some cases maintenance fees as well. Not to mention you have to pay taxes on what you do make. And to top it off, the investment firm even takes a small slice of the profits. They usually set a level in the index where you start making money. Of course they earn the spread between the current level and that high water mark.
So are these things really worth it? The answer is maybe, but certainly not with all the fees and taxes you have to pay to your broker. Being that the Chicago Options Traders group is full of very intelligent people and are very resourceful, we can make these things ourselves without all the added fees and to top it off, do it in a way in which we don’t even have to pay taxes on it.
So how do we do this? Well first of all, let’s reveal the secrets of what this really is. The first thing you do is buy a zero coupon bond. You can buy these in increments of anywhere from one year to 30 years with 10 years being the most common. A zero coupon bond is just that, it has no coupon attached to it. So you do not receive an interest payment every 6 or 12 months like you normally would if a coupon was attached. Instead the bond is sold at a discount to the future value of that bond. Then at maturity, the bond will be worth par.
One thing to remember is even though you don’t actually receive an interest payment, you will have to pay taxes on the imaginary interest each year. Unless of course, you do one of two things, execute this trade in an IRA account or a 401k plan or buy zero coupon municipal bonds, most of which are exempt from both federal and state income taxes.
So now we removed the tax element and the fee element. Now let’s add the second ingredient. That is instrument you want to participate in the upside in. It might be an index like the SP 500, or the QQQQ index. Or it might be an individual equity or possibly a group of equities. Perhaps create a power index with the likes of GOOG, EBAY, AAPL, TASR, and SIRI. You can do whatever you want, that is the beauty of it. Then what you do is buy long term leap call options in the index or stocks. Say you choose the SP 500. You might want to buy the JAN 07 ATM leaps or perhaps buy the ITM leaps to be a little more conservative. Where are we getting this money you ask? From the discount on the zero coupon municipal bond we purchased. Let’s say we buy a 20 year zero coupon municipal bond for $20,000. This bond may cost us $6,757. That would represent a yield of 5.5% a year and the tax equivalent yield could be as high as 7.5% So now we take the difference between $20,000 and $6,757 which is $13,243 and invest it in our long call leap options. If we buy the Jan 2007 calls we will have to roll them over then and perhaps buy the Jan 2010’s and so on.
The idea is, if the market trades higher over that period, you sell the leaps for a profit and then roll them to the next contract and keep doing this until the 20 years are up. One of two things will happen. If the market traded higher, you will have earned a nice return on your long SP 500 trade plus you will have the full maturity of your $20,000 bond. If the market crashes or goes no where over that 20 year period, you will have 100% of your capital returned to you when the zero coupon bond matures.
Of course technically in this example, you will have lost some money in opportunity cost. Had you placed the $20,000 in a treasury security, you could have earned the yield on that bond over the 20 years. But if the bull market continues to push forward over the next 20 years, your long call leap options will most definitely outperform any fixed income product and most equity products as well. And the best part about it, you do this with no fees on your total assets and you did this tax free. Of course you will have small commissions to pay every three years or so but it will not be 2% of your assets.
So there you have it. Now with all the money you are making trading options, you can siphon some money away in a retirement account and let it grow without the risk of blowing your retirement. Not that it would happen to any of the members of the Chicago Options Traders Group. Of course this goes without saying, but this post is in no way a recommendation for investment nor am I giving financial advice in any way.
John
posted by John at 6:36 PM
1 Comments:
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