Sanity check for a long-term leveraged investment strategy

Mr.Saver

TL;DR? ---> Jump to "The Strategy" at the end of this post.

Backgrounds

I'm young, have a stable source of income, and the income is highly disposable. I've taken advantage of pension and ISAs, and I still have some disposable income left to invest outside the tax wrappers.

Compared to my income and savings in ISA and pension, my savings outside tax wrappers is relatively small. I want to use a leverage to improve the returns on them.

Researches

I've done my research of the cost, risk and tax rules on margin loans, spread betting and options. Spread betting was ruled out because the high cost has made it unprofitable as a long-term investment. Margin loan is cheap, but comes with higher risk, and I also dislike the additional need to do Self Assessment caused by receiving more than £300 foreign dividends. At the end, I've decided to invest in LEAPS call options.

I've checked the HMRC rules, and I'm convinced that options bought and then sold is "treated as disposal of an asset. Normal CG rules apply". Therefore I don't need to report this to HMRC as long as the gains don't exceed the CGT allowance and the proceeds from the sell of the options and other assets don't exceed 4 times the CGT allowance.

I will use a diversified ETF with a liquid options market for this, and the SPDR S&P 500 (SPY) is the best fit. S&P 500 index is diversified in sectors and industries. The lack of geographical diversification is undersirable, but I can't find a better option. The good market liquidity will ensure that I can roll the options over at the cost of a narrow bid-ask spread.

The Strategy

I'm not talking about using a crazy high leverage to invest in at-the-money call options, because the odds of losing the entire lot is too high. I'm talking about using a 2:1 leverage to invest in deep in-the-money call options.

So, the strategy is to buy deep in-the-money SPY call options expiring in 2 years or longer (LEAPS) with a 2:1 leverage, and roll them over a year before their expiry. The roll over will also set a new strike price based on the price of the underlying asset to maintain a 2:1 leverage.

Estimated Returns

My estimated SPY ETF annual return excluding dividends is 7% (based on the historical data from 1993 to 2020), annual option roll over cost is 1.6% (bid-ask spread, lost time value and commissions), average effective leverage is 1.9:1 (leverage will fall as the asset price rise). If those estimations are close enough, I should be able to get an average annual return of 11.5% - 12%.

I've omitted the one off costs from the above estimations, such as the cost of getting into and exiting from the position. I've also omitted the broker account fee. Factoring in those, I should still be able to get above 10% pre-tax returns.

Questions

Will this strategy work? Did I miss something obvious? Any comments?

Username999

What happens if the SP500 drops by 20%.
When you say DITM what sort of Delta are you aiming at?

Mr.Saver

Username999 wrote: »

What happens if the SP500 drops by 20%.

S&P 500 drops by 20% doesn't affect me at all before the roll over date. When it comes to the time to roll it over, I will sell my options for less but also buy a new one for less, so it doesn't affect me that much either. The only thing might have big impact is that I will need to buy a lower strike to maintain the leverage ratio, and it would have a higher premium. Therefore I will have 3 options: put in more cash now; delay the roll over and save more cash to put in; or sacrifice a bit of the leverage and buy the same strike. It all depends on my available cash at that time.

Username999 wrote: »

When you say DITM what sort of Delta are you aiming at?

Very close to 1. To get the 2:1 leverage, I would need to buy a call strike slightly below half of the underlying price. For example, if the underlying is trading at 123.45, I would buy the 60 strike.

Alexland

So the S&P went up 30% last year, analysts are flagging increased valuations mean lower future return expectations, global growth seems to be slowing... and you want to take out a new leveraged position using complicated financial engineering?

Similar to an investment trust we are running around 10% leverage against our total financial assets (provided by our mortgage). If the opportunity looked better I might take out personal loans and 0% credit cards to invest on margin - but not at this point in the economic cycle. I don't see the attraction of investing anything more than a normal monthly pension or isa contribution right now.

Alex

bowlhead99

Mr.Saver wrote: »

Questions

Will this strategy work? Did I miss something obvious? Any comments?

Well,

I will use a diversified ETF with a liquid options market for this, and the SPDR S&P 500 (SPY) is the best fit. S&P 500 index is diversified in sectors and industries. The lack of geographical diversification is undersirable, but I can't find a better option.

You don't want an ETF with lack of geographic diversification, but can't find an ETF with better diversification than just one country's stock market? This seems to be a case of

(a) the person can't be bothered looking at what ETFs are actually available in the market? or

(b) the person does not really care about the lack of geographic diversification even though his strategy is predicated on the leveraged investment not suffering a significant drop during the two years in which he holds it?

So, the strategy is to buy deep in-the-money SPY call options expiring in 2 years or longer (LEAPS) with a 2:1 leverage

Deep in the money implies the option is currently well above water, but you don't say how deep. As S&P is currently at 3265, perhaps you are buying an option that the S&P in two years time will be over , say, 2000 (its approximate level throughout the year 2015). That option would be quite expensive, because it would take a large drop to fall down to that level.

Could easily happen of course, as it is less than a 50% drop, so your expensive option would be worthless; or at the time you hope to exit in 1 year's time it may be looking like it could much more easily expire worthless than it appears today, thus causing you to lose most of your money if not all of it.

You mention you will be using 2:1 leverage. So perhaps you mean by that, that only 1/3 of the money to buy the expensive option which could expire worthless will come from you and the remaining 2/3 will be borrowed. In which case you could lose not just all your money when the option expires worthless, but considerably more than your stake.

Or perhaps you don't mean this. Maybe by 2:1 leverage you just mean that if the market level is currently 3265 you will be buying in at a level where you don't lose all of your money unless the market falls to 2177 which is the level of the effective '2:1' borrowing, while you provide 1088 of margin, by way of [equity plus option premium], and hope that the market doesn't fall by a third from its current levels

The option premium will be high, because the option is currently well in the money, so the potential upside compared to your 'stake' is not as high as if the option was out of the money, or if you had simply bought a CFD at the current market level, but you know this; you've already reviewed and considered that you don't want an 'at-the-money' option because there is more downside risk.

What you seem to be describing is an opportunity where:

- "if my leveraged investing works out, I should be able to get an average annual return of 11.5% - 12% pre costs, and 10% pre tax";

- "if my leveraged investing doesn't work out due to a significant crash in values, I will lose all my money";

- "while I recognise that the US stock market is currently pretty much the highest CAPE of the developed world and has not had a recession for over a decade, so might be most overdue for a crash of 40-60%, and the geographic diversification is 'undesirable', I am not going to look further than that market, because it seems pretty liquid and I am greedy";

- "so I will just throw my hat into the ring and take a punt on this, because I really like the idea of 10% pre tax returns, and "I can't find a better option"; while there are a bunch of related costs which hurt my theoretical returns, it does appear to be a liquid product and at the end of the day, "I'm young, have a stable source of income, and the income is highly disposable."

Really my takeaway from your proposal is the fact that you're "young, have a stable source of income, and the income is highly disposable", which is something that can hide a multitude of sins. As you have more money becoming available to you over time, you can afford to earmark some of the money for a strategy which gives a great return until it fails; then when it fails, you still have money allowing you to start again.

So, who am I to remind you that if it was as easy as you thought, we would all be doing it.

Username999

From CBOE: SPY 325.7

Current ATM Jan 2022 SPY 325, cost to buy 1 contract = $2,994 (IV = 16%, Delta = 0.53)

Current DITM Jan 2022 SPY160, cost to buy 1 contract = $16,750 (IV = 38%, Delta = 0.91)

So if you buy the SPY160 and SPY was 160 at expiry your CALL option expires worthless?

Username999

When LEAPS first came out the favourite strategy was the Diagonal Calendar Spread.
Buy the far dated LEAP, Sell the near dated ATM.

But that didn't work either

Mr.Saver

Alexland wrote: »

So the S&P went up 30% last year, analysts are flagging increased valuations mean lower future return expectations, global growth seems to be slowing... and you want to take out a new leveraged position using complicated financial engineering?

Similar to an investment trust we are running around 10% leverage against our total financial assets (provided by our mortgage). If the opportunity looked better I might take out personal loans and 0% credit cards to invest on margin - but not at this point in the economic cycle. I don't see the attraction of investing anything more than a normal monthly pension or isa contribution right now.

Alex

I appreciate your comment and fully understand your view.

I felt the same 2 years ago, when global markets (including S&P 500) have been constantly going up in the past years, the P/E ratio had also been going up, I felt they were overvalued. I felt the same a year ago, and I still have the same feeling that the market is going to crash soon. But what matters most is not timing the market, but the time in the market, isn't it? By using a leverage I would end up with more market exposure, and in the long run this should pay out a positive return. As long as a crash doesn't wipe me out from the market, my investments will grow stronger with the recovery.

As I wrote, I will only use leverage on my savings outside tax wrappers, and this part of my savings is relatively small comparing to my ISA and pension savings. I will have more investments build up outside the tax wrappers over the coming years, so I will also benefit from the pound cost averaging if the market is to crash soon. The overall leverage across all my investments is going to be much less than the 10% figure you have, and unless the S&P 500 return is extraordinarily high, this figure is not going to grow fast.

Mr.Saver

Username999 wrote: »

From CBOE: SPY 325.7

Current ATM Jan 2022 SPY 325, cost to buy 1 contract = $2,994 (IV = 16%, Delta = 0.53)

Current DITM Jan 2022 SPY160, cost to buy 1 contract = $16,750 (IV = 38%, Delta = 0.91)

So if you buy the SPY160 and SPY was 160 at expiry your CALL option expires worthless?

That's exactly the reason why I'd roll it over far before the expiry. Even the underlying price fall 50% to 160 in a year, I can still roll it over to the same strike at a small cost. And if I have spare cash at that time, I'd roll it to a lower strike and benefit from the recovery.

Username999

If the SPY fell 50% in a year, chances are that IV would increase and would be Skewed to the far dated Option.
So you could sell your SPY160 (even at a profit if IV explodes) but the cost of the Jan 2023 would be much higher.

Implied Volatility is the REALLY difficult thing to understand, not many do!

Buying Options to make a profit is hard, few traders succeed.
Really best used to hedge a position IMHO.

But GL

Mr.Saver

Username999 wrote: »

If the SPY fell 50% in a year, chances are that IV would increase and would be Skewed to the far dated Option.
So you could sell your SPY160 (even at a profit if IV explodes) but the cost of the Jan 2023 would be much higher.

Implied Volatility is the REALLY difficult thing to understand, not many do!

Buying Options to make a profit is hard, few traders succeed.
Really best used to hedge a position IMHO.

But GL

The IV difference between one far dated option to another even further dated option for the same strike will be fairly small. For rolling from one to another, even the IV has gone sky rocket due to the recent market crash, as long as the market is still liquid, selling one and buy another at the same time wouldn't cost too much, because both of them would have very high IV by that time. The only problem is I probably can't afford a lower strike, so I won't benefit that much from the recovery, and would have to take more risk on the down side. But I can always roll it again in the same year when I have more cash available.