Index Annuities Can Provide a 170% Short-Term Gain
Trade summary: A bull call spread in American Equity Investment Life Holding Company (NYSE: AEL) using the November $30 call option which can be bought for about $2.70 and the November $35 call could be sold for about $0.85. This trade would cost $1.85 to open, or $185 since each contract covers 100 shares of stock.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $185. The maximum gain is $315 per contract. That is a potential gain of about 170% based on the amount risked in the trade.
Now, let’s look at the details.
An indexed annuity, also known as a fixed index annuity, is a type of annuity whose income payments are tied to a stock index, such as the S&P 500. Indexed annuities perform well when the financial markets perform well. People often refer to indexed annuities as hybrids of fixed and variable annuities.
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Business Wire recently reported that AEL, “a leading issuer of fixed index annuities, Värde Partners, a leading global alternative investment firm, and Agam Capital Management, LLC, an insurance solutions provider, announced they have reached agreement in principle to form a strategic partnership intended to drive value for investors, retirement planners and retirees by combining the capabilities, resources and expertise of each organization.
Under the terms of the agreement in principle, Värde will establish a Bermuda reinsurance company that would reinsure $5 billion of American Equity fixed index annuity liabilities.
American Equity and Värde will also jointly establish an asset management entity to provide insurance asset management services to the reinsurance company. American Equity is intended to have a significant minority interest in the new reinsurer and a 35% interest in the newly formed asset manager.
Each of the three companies brings distinct capabilities to the partnership.
American Equity brings distribution, policyholder service and administration, product development and insurance specific asset management expertise. Värde brings alternative asset management capabilities and Agam brings differentiated risk management solutions.
By combining these complementary capabilities in a new reinsurance company and a new asset management entity, all three partners will benefit from the growth of the reinsurance business and assets under management.
The partnership is intended to be finalized in the first half of 2021, pending regulatory approvals and customary closing conditions.
Traders seemed optimistic and pushed the stock up.
At the bottom of the chart is a momentum indicator known as the derivative oscillator. This is basically a MACD calculation that uses the value of RSI instead of closing prices in its calculation. This indicator tends to be stable and its flip to bullish could signal the beginning of a new trend.
The weekly chart confirms a bullish outlook but shows risk. Momentum is not yet bullish and the stock is near resistance.
To manage risk, a spread trade could be useful.
A Specific Trade for AEL
For AEL, the November options allow a trader to gain exposure to the stock. This trade will be open for about six weeks and allows for traders to turn over capital quickly, potentially compounding gains several times a year.
A November $30 call option can be bought for about $2.70 and the November $35 call could be sold for about $0.85. This trade would cost $1.85 to open, or $185 since each contract covers 100 shares of stock.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $185.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in AEL, the maximum gain is $315 ($35- $30= $5; 5- $1.85 = $3.15). This represents $315 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $185 to open this trade.
That is a potential gain of about 170% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
A Trade for Short Term Bulls
As with the ownership of any stock, buying AEL could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.