Sanity check for a long-term leveraged investment strategy

Jonathan_Kelvin

I’m not sure how your strategy is supposed to work here. If the market moves as the forwards imply then the options are worth far less when you sell them a year in than when you bought them. You are losing time value every day. How do you propose to turn this constant loss into an above average return?

Edited to add, you seem to believe that if the market goes up a bit then you will make money on this strategy, but you won’t, you need it to go up enough to cover your time decay.

You seem to have convinced yourself that there’s a free lunch here, that you will be gaining by buying options, but there is not. If you want leverage why not just borrow money to invest?

Mr.Saver

Jonathan_Kelvin wrote: »

I’m not sure how your strategy is supposed to work here. If the market moves as the forwards imply then the options are worth far less when you sell them a year in than when you bought them. You are losing time value every day. How do you propose to turn this constant loss into an above average return?

Edited to add, you seem to believe that if the market goes up a bit then you will make money on this strategy, but you won’t, you need it to go up enough to cover your time decay.

You seem to have convinced yourself that there’s a free lunch here, that you will be gaining by buying options, but there is not. If you want leverage why not just borrow money to invest?

Just think the time decay is the borrowing interest. Option is not mark-to-market (until rolled), so there's no margin calls, isn't this alone a good enough reason to buy options for leveraging?

Mr.Saver

under_western_skies wrote: »

OK, so I was meant to know that the flowchart you drew was only about the initial stage, and that it would change at some unspecified point when you have more invested. It would make things clearer if you'd drawn a complete flowchart for your full plan.

My intention was to check the plan that invest a small sum and gradually add more to it. I honestly didn't expect anyone to ask what if I had more invested. I thought it's obvious that a person would act differently for a small sum and a large sum. Clearly I'm wrong. Sorry I didn't make this clear. Please accept my apologies.

Besides that, the other reason why I only posted the "partial" flow chart is because I didn't draw the entire flow chart. I believe I won't need it until many years later, and it will be too big to fit in the screen and harder to read.

under_western_skies wrote: »

The parts of the plan I was calling "aggressive" or "doubling down" are where you maintain exposure by rolling over into an option with a strike price higher than half the underlying or by postponing roll over. You now say that you "will only maintain the exposure if I have no other choices", but you always have a choice. The less aggressive form of your plan (which is also simpler, and doesn't implicitly change when you have more invested) would be:

1) At a fixed interval, take the new money available for investment.

2) Sell any options held with < 12 months to expiry (blindly, i.e. completely regardless of prices).

3) Use the money from (1) and (2) to buy as many options as you can, of the contract with an expiry just over 24 months and a strike price just under half the price of the underlying.

(That description omits the (uncontroversial) part about temporarily parking any money not sufficient to buy a whole option contract in the underlying.)

That is what I would call the less aggressive version of your plan. It is less liable to blow up in extreme conditions. (I still wouldn't recommend it.)

I wouldn't take this less aggressive approach at the early stage when my income is large enough to cover the roll over cost between ATM calls after a crash. Because it still will be a small percentage of my total net asset, so I can afford to lose it, and the chance of winning and the prize of winning are both large enough to justify the gamble.

This is all about probability and outcomes. Let's say you have £1,000 to start. You'd lose £300 if you don't play the game. If you play, there's a 3/4 chance you'd lose £50, and a 1/4 chance you'd lose £700. Will you play? I will.

under_western_skies wrote: »

You don't want to model because you wouldn't believe the results blindly. Quite right about not believing them blindly; the point is not to do that, but to be able to talk about ways in which a strategy could do well or badly, and also to try out ideas about what would happen if market conditions changed in various ways.

Okay, fair enough. My another reason for not doing it is the data availability. It's easy to get stock market historical data back to early 20th century, but LEAPS did not exist before mid 2000s, so no data is available before that. The other problem is historical data for options is hard to find, I saw many companies are selling them, but I can't find anything freely available. I don't know where did those companies get their data, and how accurate are they.

It's late, and I need to get some sleep. I will read the rest of your post tomorrow. Thank you, and have a good night.

bowlhead99

Mr.Saver wrote: »

Okay, fair enough. My another reason for not doing it is the data availability. It's easy to get stock market historical data back to early 20th century, but LEAPS did not exist before mid 2000s, so no data is available before that. The other problem is historical data for options is hard to find, I saw many companies are selling them, but I can't find anything freely available. I don't know where did those companies get their data, and how accurate are they.

So from this and previous posts: you're not an experienced trader, or even a trader, you just make plans and then execute them; but you haven't modelled the outcomes of the plan under different market conditions because you couldn't get the historical data on the products you're going to be using - but you feel that your plan ought to work. You haven't drawn out the full plan because some bits of it you might not need for a long time so you will make it up when you get there depending on what you think will work when you need it to.

You will buy assets with leverage and when the market moves against you creating a geared loss, you'll accept the position of lower leverage ahead of the rebound upwards, restricting your ability to recover the losses - you won't double down when the market is cheap, but may add to the position when the market is at highs. You have a reasonable level of income but most of your money is in proper wrapped investment products so you don't have enough capital to always be able to afford to buy whole contracts, so sometimes will miss opportunities to build or protect your position while waiting for payday.

IMHO, though you've clearly put some effort into thinking about the scheme, and the use of options can protect some downside losses compared to other investment techniques (accepting a high ongoing cost of using them) - it seems to me that what you've come up with is a scheme that works nicely when the stars align and market conditions are more bouyant than expected and your leverage increases; works less well when markets are choppy and negative; and will probably fail at some point if markets sour.

In that sense it is not too far removed from any number of "get rich quick" schemes which rely on using leverage to make money when markets are favourable. So it's probably good that you are not putting loads of capital into the scheme. Though as mentioned, it seems lack of available capital is something that could stop you being able to afford to keep funding it through market lows and ultimately cause it to fail.

But frankly if you haven't looked at the market data because you couldn't get the market data, you are so far behind the market professionals that it feels like you are playing the part of punter at a casino who will eventually run out of chips at 5am before he gets to the free breakfast; rather than playing as the house and creaming off a rake until the punter runs out of chips.

Thrugelmir

Mr.Saver wrote: »

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.

Markets can stay irrational longer than investors can remain solvent.

Malthusian

This thread reminds me of how that Bogleheads thread started. A lot.

For those who haven't read it, it was about a highly intelligent 20-something with a high level of economics knowledge who talked himself into borrowing to invest. Just before the last crash hit. It left him six figures in the red, and he lost a very large chunk of his income paying it back.

I was going to say this three days ago but hadn't yet fully got my head around the OP's strategy so I held off in case it was different enough to "Market timer"'s to make the comparison lazy and unjustified.

Now I am convinced it is justified, especially after reading posts #30 onwards. It literally is like reading the opening pages of the Bogleheads thread all over again, all we're missing is a crash in the next year.

Although the strategy is different, the reason it is exactly like this thread is the way in which the OP has an answer for everything because he is putting all his effort into justifying why it's going to go right and literally none into thinking of ways in which it could go wrong. I say literally none because he is open about the fact that he didn't do any modelling. Which he justifed on the basis that he doesn't have faith in modelling. Then when it was pointed out that it wasn't a good reason, he post-hoc changed the reasoning (but not the decision) and said that it's actually because the data is too difficult or expensive to get. (If you were serious about making a success of this kind of strategy you'd just buy the data. The more unusual and risky a strategy, the more effort you need to put into it. The potential rewards should outweigh the cost.)

As I understand it the OP's strategy cannot repeat "market timer"'s level of failure because he is not using margin, only investing in LEAP options, so his maximum loss is 100% of his invested capital, not >100%. Nonetheless he is making the same mistakes of strategy, just with a lower maximum loss.

Mr.Saver

under_western_skies wrote: »

Yes, but your strategy will underperform by a larger amount in the years the market falls than it outperforms in the years the market rises. So what are the chances of it outperforming overall? You simply cannot answer this without modelling (or some other formal method).

I can't answer it. The other way of handling this situation is to sell as soon as the market crash, then buy the underlying instead. Because at crash the IV will be high, so the premium will also be higher. This would help me minimize the loss. After that, I will just wait for the market to calm down before I get back in. I haven't thought much about this alternative strategy, I'll think about it a bit more latter.

under_western_skies wrote: »

It is not answered by claiming that your expected return must have gone up because you are taking on more risk and the market is efficient. If that were the case, then a good betting method would be to always bet a little more than the Kelly criterion recommends. (In any case, the market is only efficient-ish.)

Honestly, I didn't expect the return "must have gone up", my expectation is there's a better chance to earn higher return. If the market crashes next year, it's actually better for me, because I have so little in it at the beginning. You have reminded me that in the long run, I'll need to reduce the exposure so the potential losses is more manageable. This reduce needs to happen before the actual crash. So I don't use the new money to keep it up, but rather use the new money to gain more exposure while the market is lower.

under_western_skies wrote: »

I didn't express that very well. I meant that the time-value part of the option price is lower for in-the-money than for at-the-money.

E.g. if the underlying trades at 2000, so an ATM option has a strike price of 2000, and if an ITM option has a strike price of 1000; then the market price of the ATM option is the same as its time-value, and the market price of the ITM option is 1000 + its time value. The ITM option will have a higher price, but the difference will be less than 1000.

As long as the return is higher than borrowing cost, arbitrage is still possible. One could borrow the nearly 1000 difference in price and buy the spread, then at maturity (or exercise) repay the borrowed money. If using margin to do this, there's no risk of margin calls, because the 1000 difference in strikes will not change over time. A retail investor with a large sum could borrow at 1.5% interest rate, and institutional investors surely can borrow at ever cheaper rate. This makes sure the price difference is going to be no more than years to expiry * 1.5% of the underlying asset price. For a 2 years LEAPS, that's 3% of the underlying price. It's expensive, but still affordable.

under_western_skies wrote: »

Well, it's a theory. But then future implied volatility is unknown. Current IV is low because markets have been relatively calm recently. If they become less calm, IV (and hence the cost of holding options) will rise. So if markets see-saw up and down a lot, holding options long-term will become more expensive. But will you be compensated for that?

Once I've bought it for the first time, IV going up or down isn't going to affect me that much any more. Because when I roll it, and the IV's higher, I can sell for more and it costs more to buy, or if IV's lower, I sell for less and it's also cheaper to buy. The IV difference between different strikes and different dates might get wider, but that will be a lot less than the IV change over time.

under_western_skies wrote: »

That depends on

(A) The overall compound returns from the underlying being high enough to compensate.

And the theories about expected returns being low now are not directly related to IV.

They are based on the idea that total returns = earnings yield + earnings growth + speculative premium (i.e. change in P/E ratio). (With the speculative premium either averaging 0%, or reflecting a reversion to an average P/E — depending on whose theory you're reading.)

Could there be some indirect relation between these ideas and IV? I've no idea. But unless there is, low IV shouldn't provide any comfort.

If everyone is expecting an upcoming bull or bear market, then the IV will be higher for calls and puts respectively. So a low IV does indicate that the market's expectation of the future price is close enough to today's price.

under_western_skies wrote: »

(B) The exact path that markets take to that overall return.

This is something that investors who just hold the underlying for the duration don't have to worry about. But when you use options, you do. Because your exposure to the market will be expanding or contracting as the market moves. You will be incurring higher or lower costs depending on the level of IV. And the exactly times you happen to have picked for roll overs can sometimes be crucial.

Clearly you are aware of most of the factors mentioned in the previous paragraph. These are the factors which IMHO make your plan in many ways more trading than investment. This is not to imply it's as bad as more hyperactive or discretionary trading strategies.

Thank you. Your comments gave me more things to think about.

Mr.Saver

bowlhead99 wrote: »

So from this and previous posts: you're not an experienced trader, or even a trader, you just make plans and then execute them; but you haven't modelled the outcomes of the plan under different market conditions because you couldn't get the historical data on the products you're going to be using - but you feel that your plan ought to work. You haven't drawn out the full plan because some bits of it you might not need for a long time so you will make it up when you get there depending on what you think will work when you need it to.

You will buy assets with leverage and when the market moves against you creating a geared loss, you'll accept the position of lower leverage ahead of the rebound upwards, restricting your ability to recover the losses - you won't double down when the market is cheap, but may add to the position when the market is at highs. You have a reasonable level of income but most of your money is in proper wrapped investment products so you don't have enough capital to always be able to afford to buy whole contracts, so sometimes will miss opportunities to build or protect your position while waiting for payday.

IMHO, though you've clearly put some effort into thinking about the scheme, and the use of options can protect some downside losses compared to other investment techniques (accepting a high ongoing cost of using them) - it seems to me that what you've come up with is a scheme that works nicely when the stars align and market conditions are more bouyant than expected and your leverage increases; works less well when markets are choppy and negative; and will probably fail at some point if markets sour.

In that sense it is not too far removed from any number of "get rich quick" schemes which rely on using leverage to make money when markets are favourable. So it's probably good that you are not putting loads of capital into the scheme. Though as mentioned, it seems lack of available capital is something that could stop you being able to afford to keep funding it through market lows and ultimately cause it to fail.

But frankly if you haven't looked at the market data because you couldn't get the market data, you are so far behind the market professionals that it feels like you are playing the part of punter at a casino who will eventually run out of chips at 5am before he gets to the free breakfast; rather than playing as the house and creaming off a rake until the punter runs out of chips.

This isn't a competition between me and the professionals. There's never gonna be enough people doing this to make the professionals act on it. So I will ignore them.

I don't think not having the exact data is putting me at disadvantage. History doesn't repeat itself exactly the same way, there's always going to be something that's different. What works well in the past might not work in the future, and what didn't work in the past might do well in the future. So why wasting time to prove something would've worked fine in the past? I'd rather put together a plan, then think it through the worst case scenario and see if I can afford it, and think it through the typical scenarios and see if it makes better returns. I don't need those not publicly available data to do this, the underlying asset's price is enough for me to make the guess.

Historically, the market goes up more often than down, and there's also a tendency to maintain the trend. So a plan to increase leverage on the up and decrease leverage on the down makes sense. Other than the down side risk of leverage, another problem I know is a flat but fluctuating market spanning multiple years. Because when the market repeatedly going up and down year after year, the plan would have effectively become repeatedly buying high and selling low. Tactically pick the time of roll may help, but that adds emotional risk and also increases transactional cost, so I'd rather avoid it.

I'm going to take all the comments into consideration, and refine the plan, make sure I fully understand the risk and reward before I decide to put it into action or give it up.

Mr.Saver

Malthusian wrote: »

This thread reminds me of how that Bogleheads thread started. A lot.

For those who haven't read it, it was about a highly intelligent 20-something with a high level of economics knowledge who talked himself into borrowing to invest. Just before the last crash hit. It left him six figures in the red, and he lost a very large chunk of his income paying it back.

I was going to say this three days ago but hadn't yet fully got my head around the OP's strategy so I held off in case it was different enough to "Market timer"'s to make the comparison lazy and unjustified.

Now I am convinced it is justified, especially after reading posts #30 onwards. It literally is like reading the opening pages of the Bogleheads thread all over again, all we're missing is a crash in the next year.

Although the strategy is different, the reason it is exactly like this thread is the way in which the OP has an answer for everything because he is putting all his effort into justifying why it's going to go right and literally none into thinking of ways in which it could go wrong. I say literally none because he is open about the fact that he didn't do any modelling. Which he justifed on the basis that he doesn't have faith in modelling. Then when it was pointed out that it wasn't a good reason, he post-hoc changed the reasoning (but not the decision) and said that it's actually because the data is too difficult or expensive to get. (If you were serious about making a success of this kind of strategy you'd just buy the data. The more unusual and risky a strategy, the more effort you need to put into it. The potential rewards should outweigh the cost.)

As I understand it the OP's strategy cannot repeat "market timer"'s level of failure because he is not using margin, only investing in LEAP options, so his maximum loss is 100% of his invested capital, not >100%. Nonetheless he is making the same mistakes of strategy, just with a lower maximum loss.

Very interesting reading, I've managed to kill 3 hours time on that, and will continue tomorrow.

Mr.Saver

Malthusian wrote: »

This thread reminds me of how that Bogleheads thread started. A lot.

For those who haven't read it, it was about a highly intelligent 20-something with a high level of economics knowledge who talked himself into borrowing to invest. Just before the last crash hit. It left him six figures in the red, and he lost a very large chunk of his income paying it back.

I was going to say this three days ago but hadn't yet fully got my head around the OP's strategy so I held off in case it was different enough to "Market timer"'s to make the comparison lazy and unjustified.

Now I am convinced it is justified, especially after reading posts #30 onwards. It literally is like reading the opening pages of the Bogleheads thread all over again, all we're missing is a crash in the next year.

Although the strategy is different, the reason it is exactly like this thread is the way in which the OP has an answer for everything because he is putting all his effort into justifying why it's going to go right and literally none into thinking of ways in which it could go wrong. I say literally none because he is open about the fact that he didn't do any modelling. Which he justifed on the basis that he doesn't have faith in modelling. Then when it was pointed out that it wasn't a good reason, he post-hoc changed the reasoning (but not the decision) and said that it's actually because the data is too difficult or expensive to get. (If you were serious about making a success of this kind of strategy you'd just buy the data. The more unusual and risky a strategy, the more effort you need to put into it. The potential rewards should outweigh the cost.)

As I understand it the OP's strategy cannot repeat "market timer"'s level of failure because he is not using margin, only investing in LEAP options, so his maximum loss is 100% of his invested capital, not >100%. Nonetheless he is making the same mistakes of strategy, just with a lower maximum loss.

That guy, market timer, got himself into the $210k debt, because:
1. He borrowed money from credit cards at 0% introductory rate to invest, but he must repay them all in a few years before the introductory rate ends, or the credit cards will charge him high interest rate.
2. He was using extremely high leverage rate. At some point during the financial crisis, he said his leverage was 10:1. In fact the 1 was also mostly borrowed money from credit cards, so the leverage rate is even greater than what he thought.
3. He didn't stick to his plan. He was increasing leverage on the way down, which wasn't a part of his original plan.
4. He was trying to time the market. In the middle of 2008 he thought the market was at the bottom, and increased his market exposure. We all know that, in hindsight, it wasn't the bottom.
5. He bought futures, which has short expiration date and needs to be rolled every a few months. He wouldn't have time to get cash before the future expires if the market is against him.
6. His investments were marked to market every trading day, and he faced multiple instances of forced liquidation because he couldn't meet the margin calls. He could've avoided this if he didn't buy on margin.
7. He didn't benefit from dollar (pound) cost averaging. He borrowed and invested everything in a short window of time.

People says he was unlucky. But with all the mistakes he made, he was lucky enough that the market crashed almost immediately after he borrowed on his 0% credit cards, so he had a couple of years to repay the credit card debts before the 0% deals run out. It could end up much worse that this if the market crashes right before the deals run out and he wanted to repay the debts by selling the investments.

By learning all his mistakes, I can better avoid them. Thanks for providing the link to that interesting read.