Important update! We have recently reviewed and updated our Forum Rules and FAQs. Please take the time to familiarise yourself with the latest version.
Sanity check for a long-term leveraged investment strategy
56 replies
3K views
Quick links
Essential Money | Who & Where are you? | Work & Benefits | Household and travel | Shopping & Freebies | About MSE | The MoneySavers Arms | Covid-19 & Coronavirus Support
Replies
I'd do a ton of what ifs using data from here...
http://www.cboe.com/delayedquote/quote-table
I hope you don't have the expensive education I had!
My initial attempt was searching on the internet for most liquid ETF options, which led me to SPY and a few other ETFs focused on other countries, regions or sectors.
When I said 2:1 leverage, I meant buy the option with half of the money, and "borrow" the other half. Therefore 2 (the value of the investment) to 1 (my money). In the S&P 500 case, the index is at 3265, and SPY unit price is 1/10 of the index, so $326.50. I would buy the 160 strike, which costs a bit over $167. Even it fall by more than 50% to below $160, the option is not worthless as long as it still has the time value (i.e. not due to expire soon), this is exactly why do I intend to roll it over far before the expiry. If the 1 year to expire option seems worthless, the 2 years to expire option with the same strike would also seem not worth much, therefore I can still roll it over for a small cost.
No, I meant I will buy the call option with strike slightly below half of the underlying price. The premium for such call option would be slightly higher than the half of the underlying price. Therefore I would pay half of the underlying price today, and the other half latter. And by rolling it over annually, I can delay the "latter" indefinitely. Even the market does fall more than 50%, the option is not worthless yet, as it would still have time value, so I can still sell it and roll over to a later date.
Yes, the option premium will be high, in fact slight higher than the cost of half of the underlying asset. The upside is roughly the same as the underlying asset as it has a Delta very close to 1, but it only costs half.
Not all my money, because I don't wait till the expiry. I roll it over a year before it expires.
You are right. This is my fault. I will do my research again and make it right.
When I said "I'm young, have a stable source of income, and the income is highly disposable" I meant to say that I can afford to take the risk of losing a large percentage of it and then recover in 10 years. I will not take the risk to get wiped out of the market and never get the chance to recover.
Just like asset allocation between equity and bonds (or cash). Having 80% equity is suitable for many people, but it's certainly not for everyone. 80% equity will have a great chance to generate a better return than 40% equity, but many people still chose 40%. The same applies to leveraged investment. It's just a higher equity level, say 120% equity and -20% cash. It's not for everyone, but it will be suitable for some people.
You have to set the actual losses in years when you are rolling over after a market crash which hasn't yet recovered against the higher profits in years when there's no crash. You expect to outperform an equivalent unleveraged portfolio by c. 3% in each good year (and most years will be good), but in a crash year you would could underperform the unleveraged portfolio by 30%, 60% or more. In a really bad crash, you could lose so much that you'd have no realistic chance of catching up with the unleveraged portfolio by sticking to the same strategy for the rest of your lifetime. (And in reality, we all know you wouldn't stick to it after that.) If you don't understand that this is a possibility, then you haven't really understood what you're proposing to do at all.
It is 100% false mental accounting to mention that you could put more money in after suffering losses. You could do that anyway. If you buy the unleveraged S&P 500, and it crashes, hopefully you would buy more of it with any new money that becomes available. But doubling down on a leveraged strategy after a crash is very different. Phase 2 of the crash could lose most of your new money, too; and then (if not scared off from trebling down) you might not have much new money available before the bounce back happens, which means you'd never get you losses back.
Without leverage, if the S&P 500 recovers to the level before the crash, and you don't panic-sell before it does, you will definitely recover your loses. With leverage, that is absolutely not the case: the index can recover to the pre-crash level, but you can still be nursing losses — which are therefore permanent. Your strategy does take that risk. Well, not 100% wiped out, providing that you stick to selling options with 1 year to expiry, but losses so large that you have no realistic prospect of recovering them.
tl;dr: insane
Could you elaborate on why can I not roll it over to the same strike but a later expiry at a small cost if the market crashes? Because this would allow my investment to recover with the market at a small roll over cost.
Sell to Close JAN21 = +$2,032
Buy to Open JAN22 = -$2,994
So it would cost approx $962 to roll today (plus charges).
Is that a "small roll over cost"?
( 1 contract is 100 times the Option price)
As 999 says, is it small?
But also: as you yourself have suggested, the more consistent form of this scheme is to roll over at a lower strike price (to maintain leverage). Which reduces your exposure to the market, so you do not benefit fully from a market recovery.
The alternative, of rolling over at the same strike price, will pay off if the market recovers soon enough. But if it instead takes another step down, your capital shrinks further, and you face a dilemma at the next roll over time: reduce the strike price (locking in part of your losses), or up the leverage again? (E.g. If the market falls 50%, will you be buying at-the-money call options?) In the worst case, it may not be possible to maintain the strike price, even if you want to, without adding a lot more capital than the dwindling amount currently invested in options.
Is your plan about handling roll overs going to be mechanical or discretionary — i.e. will you use judgement about whether to adjust strike price or roll date? If you're using judgement, doesn't that require you to have some kind of trading skill?
And IMHO, this plan (mechanical or discretionary) should be about what you do with the money already invested in options. Adding new money is fine, but it shouldn't be used to paper over earlier losses.
Please keep digging into exactly what you plan to do with roll overs after a crash. And I think you'll find that you are not certain to make money from this scheme (compared to an unleveraged benchmark portfolio).
On the other hand, when the market is on the rise, this strategy would keep increasing the leverage, and benefit more from the long term upward trend.
I will aim at maintaining the leverage at 2:1 whenever the contract is rolled over.
The only chance to break the above rule is the following 3 conditions are all met at roughly the same time:
The contract is expiring soon (or I can save cash from income)
The market has recently experienced a crash (or why would I worry?)
All of the above will suffer the losses and won't capture twice of the full recover, but that's the nature of leveraged investment, it amplifies both the up and down. In the unfavoured market condition I will end up losing more that unleveraged investment, but in the favourable condition I will also gain more. In the long run, I'm optimistic about the market, and I'm willing to take the additional risk for a better chance to get higher returns.
I intend to keep it mechanical, unless I cannot (e.g.: insufficient cash), but I will then aim to get it fixed ASAP.
Thank you for highlighting this. I will write a comprehensive plan, focusing on the invested money, but also factoring in the cash flow. I will post an update here soon.
I've never considered this as "certain to make money" scheme. I think of it as a "higher market exposure" plan, which has a better chance to have a higher return than 100% market exposure.
As I premised, the trade plan.
Note that in practice I would try to minimize the transaction cost, and do it quarterly rather than monthly.
I still need to do the research on the ETF that's best suited for this.