Mr.Saver's Long-term Leveraged Investment Strategy Using LEAPS

Mr.Saver

Winebottle said:

I've tried various forms of leverage. It's interesting because it has the potential to produce astonishing returns when compounded over time.

I find the mortgage your retirement idea easy to implement. For example, I didn't have any spare cash last year so borrowed £40k using an additional mortgage to fill up our ISAs. 

I find the separation between the assets and the debt helpful psychologically. I can afford the repayments which are lumped in with the rest of the mortgage that went towards the house. I'm not going to sell the shares which are lumped in with the rest of my investments. I don't really track the two together. If the shares go down, I will have in theory lost more than the £0 of my own money I put in but it is just part of my overall personal balance sheet so I don't care.

It is much more difficult to stick to when the leverage is built into the product. Having busted out of many futures contracts last year, I can tell you it isn't much fun. Even if you believe in the strategy long term, it is difficult to keep putting money in when you keep losing. I doubt many people have managed to do it consistently for 30 years.

Finding what works for you is also important. TBH I have considered 0% credit card, consumer loans, margin loans, futures and options, and I settled on options. The two problems with future are short expiration and high leverage rate. Short expiration result in additional administrative costs (time and transaction cost), and high leverage rate means the investor can quickly run into problems in a falling market. Combining these two together made it even worse, because it's marked to the market every time you need to roll over the future contracts, in a down market, you will be forced to come up with more cash or sell and exit at a loss.

Over the long term, to survive a 60% market crash and then remains flat for 10 years without adding additional cash, margin loan at 1.2x leverage or less works, and LEAPS options at 2x or less also works.

Winebottle said:

I haven't given up on the idea. If the markets keep falling, I may try again with lower leverage and more frequently rebalancing.

First of all, market timing is certainly a bad idea, and combining it with leverage is not going to make it a better idea.

I don't know how high is your leverage rate, but based on some back tested data, to maximise the long term return, the ideal leverage rate is between 1.5x to 2x. Leverage rate above 2x actually results in lower returns due to more frequent rebalancing and decays. Leverage rate above 4x has a decent chance to wipe out the entire portfolio, leave the investor with zero balance at the end.

I would highly recommend you keep your leverage rate no more than 2x if you want to play the long term game.

Winebottle said:

I also recently purchased my first leveraged ETF. 

I assume you are aware of and taken into consideration the decay problem of daily leveraged ETFs. If not, I highly recommend you to read about it before dipping in with your own money.

Winebottle

I did the 0% credit card thing when I was younger but can't be doing with the hassle of it now.

The roll costs on futures are negligible, they are very liquid markets. For example, you can roll the E-mini for a spread of 1 tick which is $12.50. If you do that 4x a year, it is not much considering the notional value of contract is $200k. 

The marked to market problem isn't just an issue when you come to roll, you need to add more margin just to stay in your existing contract when the market falls.

I can understand options if you want to trade around a view on volatility but if you just want to bet on the market going up over a long period of time, I don't see the appeal of the asymmetric return profile.

I've concluded that the argument that leveraged ETFs suffer volatility decay is misleading because it is only half of the story. Why would you expect daily rebalancing to produce the same returns as never rebalancing? They are different strategies that will obviously produce different results.

If the market goes down and you cut your bet size in response, you will obviously do worse than someone who didn't if the market bounces back. On the other hand, you will lose less if the market continues to fall. The same is true on the upside.

The rebalancing is actually a good thing for balancing the expected return with the risk of ruin. People have studied it in relation to gambling. If you play many hands of cards, with each hand giving you a postive expectation, the optimum bet size is a function of how much money you have left. 

The gambler who adjusts his bet size, will do worse if he loses a hand and then wins a hand (or wins a hand and then loses a hand) compared to a gambler who bets the same amount each hand. You could say he suffers volatility drag. On the other hand he will do better on winning or losing streaks.

What matters is getting the money down at the favourable odds but not betting too much to risk busting out of the game and that means you should rebalance. "Decay" isn't the issue.

Mr.Saver

Winebottle said:

The roll costs on futures are negligible, they are very liquid markets. For example, you can roll the E-mini for a spread of 1 tick which is $12.50. If you do that 4x a year, it is not much considering the notional value of contract is $200k. 

The marked to market problem isn't just an issue when you come to roll, you need to add more margin just to stay in your existing contract when the market falls.

You are right. The main problem is the maintenance margin. Having to come up with large sum at short notice is going to be a big headache for most people.

Winebottle said:

I can understand options if you want to trade around a view on volatility but if you just want to bet on the market going up over a long period of time, I don't see the appeal of the asymmetric return profile.

Not really. A very deep in-the-money call option's delta is infinitely close to 1, which means for every $1 price movement of the underlying, the option's price also moves by $1.

Winebottle said:

I've concluded that the argument that leveraged ETFs suffer volatility decay is misleading because it is only half of the story. Why would you expect daily rebalancing to produce the same returns as never rebalancing? They are different strategies that will obviously produce different results.

If the market goes down and you cut your bet size in response, you will obviously do worse than someone who didn't if the market bounces back. On the other hand, you will lose less if the market continues to fall. The same is true on the upside.

No one expects to see these two strategies producing the same result. The reason why daily rebalancing hurts long-term return very badly is because there's a nearly 50-50% chance for any trading day to end with a gain or loss. You may get lucky and the positive days and negative days are clustered, or you may get unlucky and see the market keeps bouncing up and down every day. A daily 2x ETF may still result in a lose in the unlucky case, even if the market did end up a lot higher.

For example, if the market has produced the sequence of daily return -4.7%, +5%, -4.7%, +5%, ... repeated for an entire year (366 days, 183 full cycles), the rate of return at the end of the hypothetical year will be roughly 12.6%, looking good. However, a perfect (no tracking error and no fee) daily 2x ETF's rate of return will be a shocking number, -46%. Ouch! That hurts. The daily 2x ETF lost nearly half of its value in the same year that the market went up by 12.6%. If the leverage was done in any another way that rebalances less often than weekly, the return is going to be positive at the end of the hypothetical year. 

Now, you can see why buy and hold daily reset leveraged ETF is such a bad idea.

Winebottle said:

The rebalancing is actually a good thing for balancing the expected return with the risk of ruin. People have studied it in relation to gambling. If you play many hands of cards, with each hand giving you a postive expectation, the optimum bet size is a function of how much money you have left. 

I think you are referring to Kelly bet.

Winebottle said:

The gambler who adjusts his bet size, will do worse if he loses a hand and then wins a hand (or wins a hand and then loses a hand) compared to a gambler who bets the same amount each hand. You could say he suffers volatility drag. On the other hand he will do better on winning or losing streaks.

This is not true. For Kelly bet strategy, the sequence of event does not affect the end result, as long as the total number of winning and losing bets are the same. In fact, a gambler employs the Kelly bet strategy will always end up better off than a gambler who places fixed size bets in the same game, as long as sufficient number of games were played.

Winebottle said:

What matters is getting the money down at the favourable odds but not betting too much to risk busting out of the game and that means you should rebalance. "Decay" isn't the issue.

This is not true. Kelly bet strategy doesn't apply to buy and hold leveraged ETFs.  The sequence of events doesn't affect the result of Kelly bet strategy, but it has a huge impact on the end result of leveraged ETF. Daily reset leveraged ETF's decay is a real issue, and I'm afraid that you are underestimating its potential impact to your end wealth.