Sanity check for a long-term leveraged investment strategy

Username999

Rule of thumb I used (back in the day) was to ROLL the option when there's very little THETA left as close to expiry as possible. Not sure of any merits to ROLL otherwise.

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!

Mr.Saver

bowlhead99 wrote: »

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?

Fair point. I'll dig into this further.

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.

bowlhead99 wrote: »

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.

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.

bowlhead99 wrote: »

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

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.

bowlhead99 wrote: »

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.

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.

bowlhead99 wrote: »

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";

Not all my money, because I don't wait till the expiry. I roll it over a year before it expires.

bowlhead99 wrote: »

- "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";

You are right. This is my fault. I will do my research again and make it right.

bowlhead99 wrote: »

- "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.

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.

bowlhead99 wrote: »

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

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.

Mr.Saver

Username999 wrote: »

Rule of thumb I used (back in the day) was to ROLL the option when there's very little THETA left as close to expiry as possible. Not sure of any merits to ROLL otherwise.

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!

I really hope I will never have those expensive educations.

under_western_skies

Mr.Saver wrote: »

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 ...

... you will have actually lost money, and it could well be nearly all of the money you've put into this scheme. It can't be all the money you've put in, because you're selling the options when they have 1 year to go (though if you delayed until expiry, it could be all).

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.

Mr.Saver wrote: »

I will not take the risk to get wiped out of the market and never get the chance to recover.

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

Mr.Saver

under_western_skies wrote: »

... you will have actually lost money, and it could well be nearly all of the money you've put into this scheme. It can't be all the money you've put in, because you're selling the options when they have 1 year to go (though if you delayed until expiry, it could be all).

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

Thank you for registering the forum and posting your first reply to help me. I really appreciate it.
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.

Username999

Roll JAN21 SPY325 (ATM) to JAN22 SPY325 (ATM)

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)

under_western_skies

Mr.Saver wrote: »

Thank you for registering the forum and posting your first reply to help me. I really appreciate it.
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.

You're welcome.

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).

Mr.Saver

Username999 wrote: »

Roll JAN21 SPY325 (ATM) to JAN22 SPY325 (ATM)

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)

Yes, $962 sounds like a lot. But if the underlying had a 50% fall and is trading at 325, it would have costed about $16,700 to buy. The $962 is only 5.76% of that. Considering this is a once in a decade event, a 6% loss isn’t such a big deal, right?

Mr.Saver

under_western_skies wrote: »

You're welcome.

As 999 says, is it small?

It's still below 6%, and we are not talking about a 50% crash every a couple of years, this is more of a once in a decade event. I'd think of it as an expensive transaction cost in a rare market condition.

under_western_skies wrote: »

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.

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.

under_western_skies wrote: »

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.

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:

I'm low on cash (or I can buy a lower strike)
The contract is expiring soon (or I can save cash from income)
The market has recently experienced a crash (or why would I worry?)

The chance for all of those to happen at the same time is slim. When it does happen (and I'm sure it eventually will), I would have to live with the fact that I cannot deleverage immediately, and I would have to roll it over to the same strike and then build up cash before I can roll it again and reduce the leverage. In the worst case, the same strike isn't available, I would sell my other assets outside tax wrappers (due to the nature of the 100 shares per contract, I will need to hold odd number of shares outside this strategy) and use the proceed to fund the roll. In the unlikely event that I don't have anything to sell, I'd have no choice but to delay the roll by a month or two, and build up more cash from my income.

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.

under_western_skies wrote: »

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?

I intend to keep it mechanical, unless I cannot (e.g.: insufficient cash), but I will then aim to get it fixed ASAP.

under_western_skies wrote: »

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.

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.

under_western_skies wrote: »

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).

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.

Mr.Saver

Hi under western skies,

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.