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  • FIRST POST
    • Mr.Saver
    • By Mr.Saver 11th Jan 20, 10:37 PM
    • 353Posts
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    Mr.Saver
    Sanity check for a long-term leveraged investment strategy
    • #1
    • 11th Jan 20, 10:37 PM
    Sanity check for a long-term leveraged investment strategy 11th Jan 20 at 10:37 PM
    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?
Page 2
    • Mr.Saver
    • By Mr.Saver 12th Jan 20, 4:13 PM
    • 353 Posts
    • 172 Thanks
    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.
    • bowlhead99
    • By bowlhead99 12th Jan 20, 5:56 PM
    • 9,793 Posts
    • 17,915 Thanks
    bowlhead99
    The 'uncharted territory' you mention.

    Looking at broad global indexes, the FTSE All-World had a peak to trough drawdown of 58% between autumn 2007 and March 2009, though after March 2009 when world governments got together and slashed interest rates to the floor and embarked upon massive money-printing, there was a rapid rebound, so it didn't stay below 50% for as long as 9 months, but the floor was about 18 months after the peak. You could not necessarily say that a rebound from the next crash would be as rapid as the last couple that we saw (from 03 and from 09 floors) because there is not necessarily the same capacity for global quantitative easing and interest rate reductions.

    In 1989, Japan's TOPIX index for the Tokyo stock exchange peaked about 2885. In 1998, its low was 980. A decade and a half later, in 2013 it had a low of 872, but a high of 1302. In 2018, its low was 1415 (still 50% below its peak 29 years earlier) although its high was over 1900; it is 1735 today.

    Similarly Japan's Nikkei 225 fell from 37,189 in Jan 1990, losing 35% over the course of that year and the subsequent decade from 1991 in Japan was known as the 'lost decade' due to the effects of the gradual collapse of the asset price bubble. After the earthquake in 2011, the Nikkei was at 8160.

    So, single country indexes are best avoided. This is not to suggest the US has a price bubble due to collapse to the same extent that Japan did, and the constituents of its index are more varied than Japan's at the time. However, Japan was once the biggest world stockmarket and now it isn't. Faith in the S&P500 may to some extent be similarly misplaced; a broader index would probably be better, even if S&P ETFs are cheap to trade.
    Last edited by bowlhead99; 12-01-2020 at 5:58 PM.
    • Mr.Saver
    • By Mr.Saver 12th Jan 20, 5:57 PM
    • 353 Posts
    • 172 Thanks
    Mr.Saver
    Hi bowlhead99,

    I've done my research on ETFs suitable for this strategy. I applied the below filtering criteria on all equity ETFs, and only 6 ETFs ended up in my list.
    Expense ratio <= 0.8% (filtering out expensive funds)
    Number of holdings >= 500 (physical replication broad market index fund)
    Option volume >= 1,000 (filtering out funds with very bad option liquidity)

    The 6 ETFs are:
    SPY, SPDR S&P 500 ETF TRUST
    EEM, ISHARES MSCI EMERGING MARKET
    IWM, ISHARES RUSSELL 2000 ETF
    EFA, ISHARES MSCI EAFE ETF
    VWO, VANGUARD FTSE EMERGING MARKE
    IVV, ISHARES CORE S&P 500 ETF

    Excluding the emerging market and small-cap funds, there's only 3 left. Two of them are S&P 500 trackers, and the the other one is a MSCI EAFE tracker.

    None of them on their own can represent the global market. My best idea would be combining two ETFs, SPY and EFA. Holding 60% of SPY and 40% of EFA, the portfolio is fairly close to the MSCI World index.

    The only problem is it needs a lot more cash to start with. Because SPY is trading at $325.6, this portfolio would require nearly $28,000, and rebalancing can be very hard.
    • Mr.Saver
    • By Mr.Saver 12th Jan 20, 6:02 PM
    • 353 Posts
    • 172 Thanks
    Mr.Saver
    The 'uncharted territory' you mention.

    Looking at broad global indexes, the FTSE All-World had a peak to trough drawdown of 58% between autumn 2007 and March 2009, though after March 2009 when world governments got together and slashed interest rates to the floor and embarked upon massive money-printing, there was a rapid rebound, so it didn't stay below 50% for as long as 9 months, but the floor was about 18 months after the peak. You could not necessarily say that a rebound from the next crash would be as rapid as the last couple that we saw (from 03 and from 09 floors) because there is not necessarily the same capacity for global quantitative easing and interest rate reductions.

    In 1989, Japan's TOPIX index for the Tokyo stock exchange peaked about 2885. In 1998, its low was 980. A decade and a half later, in 2013 it had a low of 872, but a high of 1302. In 2018, its low was 1415 (still 50% below its peak 29 years earlier) although its high was over 1900; it is 1735 today.

    Similarly Japan's Nikkei 225 fell from 37,189 in Jan 1990, losing 35% over the course of that year and the subsequent decade from 1991 in Japan was known as the 'lost decade' due to the effects of the gradual collapse of the asset price bubble. After the earthquake in 2011, the Nikkei was at 8160.

    So, single country indexes are best avoided. This is not to suggest the US has a price bubble due to collapse to the same extent that Japan did, and the constituents of its index are more varied than Japan's at the time. However, Japan was once the biggest world stockmarket and now it isn't. Faith in the S&P500 may to some extent be similarly misplaced; a broader index would probably be better, even if S&P ETFs are cheap to trade.
    Originally posted by bowlhead99
    Thank you. I posted the previous one before I saw this new post. Your comment on this issue is a very valuable input for me.
    • bostonerimus
    • By bostonerimus 12th Jan 20, 6:06 PM
    • 3,588 Posts
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    bostonerimus
    This needs very little thought at all; gamblers or scoundrels invest with borrowed money. You can convince yourself that everything will be alright, but the costs and risks of failure are seldom correctly evaluated. Greed reinforced by numerology can be very dangerous in personal finance and it should be eliminated from any strategy. Leave option trading up to the professionals.
    Last edited by bostonerimus; 12-01-2020 at 6:12 PM.
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    • Mr.Saver
    • By Mr.Saver 12th Jan 20, 6:40 PM
    • 353 Posts
    • 172 Thanks
    Mr.Saver
    This needs very little thought at all; gamblers or scoundrels invest with borrowed money. You can convince yourself that everything will be alright, but the costs and risks of failure are seldom correctly evaluated. Greed reinforced by numerology can be very dangerous in personal finance and it should be eliminated from any strategy. Leave option trading up to the professionals.
    Originally posted by bostonerimus
    People who invest before pay off a mortgage is also investing borrowed money, but what's wrong with that?

    Leverage is double-edged sword. Used properly, it will do more good than harm.
    • bostonerimus
    • By bostonerimus 12th Jan 20, 6:57 PM
    • 3,588 Posts
    • 2,879 Thanks
    bostonerimus
    The risk associated with a mortgage is far less than options trading, but I do take your point which is why I made extra mortgage payments in lieu of some of my fixed income allocation in my portfolio. I’m now mortgage free, which is boring but also highly liberating.
    Misanthrope in search of similar for mutual loathing
    • under western skies
    • By under western skies 13th Jan 20, 6:49 PM
    • 6 Posts
    • 4 Thanks
    under western skies
    I have a few more comments ... But really, you need to be modelling how your trade plan would have performed with historic data (as well as attempting to make some allowances for how the future won't exactly resemble the past). I'm just offering a few generalizations — and if you haven't thought of some of them, then consider that there are probably plenty more I've missed.

    Combining new money and the proceeds from selling options that are to be rolled over makes sense from an operational point of view. (For one thing: it ensures you buy as many whole option contracts as you can with your total available capital.) But it's very misleading in terms of the theory of how your strategy is performing.

    Why do I say that? Because I get the impression that you think that, so long as you are able to maintain your exposure to the underlying throughout a crash until the recovery, you haven't lost anything. And this is completely untrue. The comparison should always be with just buying the underlying (S&P 500), and if you did that, during a crash all your new money would be used to buy more of the underlying at "for sale" prices. With your options strategy, you instead have to use some or all of your new money to maintain your current exposure; so there is an opportunity cost. You are effectively trying to cover up the fact that your existing position in options is losing money by mixing it with the new money.

    The more clear-sighted way to look at it is to separate (logically, not operationally) the handling of new money and roll overs. When you look at it like this, you have 2 choices when it's time to roll over an option that's losing money: keep to your target leverage (by reducing exposure) or maintain exposure (by increasing leverage). (Except that, in extreme cases, the latter may not be possible.) That's the choice to consider.

    The way your plan mixes old and new money has the effect that how aggressive you are depends on the relative sizes of the option positions already held and of the new money being added. When the new money is relatively large, compared to what's already invested, it is less aggressive, because the exposure the new money can buy, while sticking to the target leverage, would in most market conditions be enough to cancel out the reduction in exposure from rolling over losing contracts into reduced exposure to maintain target leverage. But as the invested capital becomes larger relative to new money, the new money can't paper over losses so easily, and you could easily start ramping up the leverage. So this strategy is more likely to blow up badly after it's been going for some years. (Did you know that? If not, that's why you should have been modelling it.)

    Is there any sense a strategy becoming more aggressive as you have more invested (relative to the size of new cash)? I don't think so. This is another reason to separate (logically) the handing of roll overs and new cash. I.e. to have a rule about how to handle roll overs which doesn't refer to what new money is available.

    The more aggressive approach, of always maintaining exposure (if at all possible), is IMHO pretty mad if you attempt to follow it with no limit. Ultimately, you could end up buying far out-of-the-money options, waiting until they have nearly expired, still far out-of-the-money, and having lost most of their value when you bought them, and then reinvest the dwindling proceeds into new, longer-term, out-of-the-money options. Does that make any sense? If not, where do you stop?

    In your plan as stated, there is no stopping digging when you're in a hole. (There is only a variable level of aggressiveness, increasing as you have more capital invested.)

    I think any experienced trader (which I'm not — I just know enough to know I shouldn't be trading) will say there is a point where you have to back off and reduce exposure. You can't sanely always keep doubling down. (It's an appropriate thread title.)

    Of course, we can all see why you don't want to maintain leverage by reducing exposure. Because then you don't get the 2X returns of the underlying (less the costs of using options) that you were aiming for. But the lesson is that leverage doesn't do exactly what you might want it to do. All it does is give you returns with a different shape from the underlying, which may or may not be higher. And, however you do it, with more ways it just might blow up in your face.

    When considering how the effects of increasing leverage after a market fall, you'll note that (for instance) an at-the-money option is more expensive than a deep in-the-money option (for the same level of exposure), because the former is a 1-way bet, the latter a 2-way bet. So you are spending more on the time value of the option (which you then allow to decay as you hold the option, hoping that the return from the underlying compensates you for that loss). But in addition, after a market crash, volatility and therefore option prices are likely to rise; making increasing leverage even more expensive. All this makes doubling down more costly, and more risky. And this information should be fed into your modelling. (I think I already mentioned that you need to model this.)

    But without modelling, we can say: using increased leverage during a crash adds risks, so you may be unable to stick it out until the recovery. But it also adds costs, so, even if you are able to stick it out until the recovery, the gains from staying fully invested may not be enough to cover those increased costs.

    And a slightly different point: previously, I said most years would be good for this strategy. I was thinking that most years have no big crash. However, even aside from crashes and extreme events, in a mild year, with low but positive returns for an underlying index, the returns from an option strategy will be lower than the index, and could be a small loss, due to the cost of rolling (e.g. selling a 24-month option to buy a 12-month option). This alone, given many are projecting low returns from equities going forward, is a pretty good reason not to buy options now, when you could just buy the underlying index instead.
    • bostonerimus
    • By bostonerimus 13th Jan 20, 7:19 PM
    • 3,588 Posts
    • 2,879 Thanks
    bostonerimus



    But in addition, after a market crash, volatility and therefore option prices are likely to rise; making increasing leverage even more expensive. All this makes doubling down more costly, and more risky.
    Originally posted by under western skies
    Tell that to Nick Leeson.
    Last edited by bostonerimus; 13-01-2020 at 7:22 PM.
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    • Mr.Saver
    • By Mr.Saver 13th Jan 20, 10:28 PM
    • 353 Posts
    • 172 Thanks
    Mr.Saver
    But really, you need to be modelling how your trade plan would have performed with historic data (as well as attempting to make some allowances for how the future won't exactly resemble the past).
    Originally posted by under western skies
    I could do the modelling, but I didn't do it, because I don't have much faith in financial modelling. Changing a few parameters can make a completely different outcome, and many of them (future inflation rate, interest rate, etc.) are predictions and expectations rather than facts. I'm pretty sure most fund managers have done their modelling, but did this prevent them from losing money? I don't think so.

    Instead of wasting time to fool myself with those seem prefect strategies from back tested models and then fail in the real world, I'd rather make my plan based on what is known, and then deal with the unknowns when they become known.

    Combining new money and the proceeds from selling options that are to be rolled over makes sense from an operational point of view. (For one thing: it ensures you buy as many whole option contracts as you can with your total available capital.) But it's very misleading in terms of the theory of how your strategy is performing.

    Why do I say that? Because I get the impression that you think that, so long as you are able to maintain your exposure to the underlying throughout a crash until the recovery, you haven't lost anything. And this is completely untrue.
    Originally posted by under western skies
    No, I don't expect "haven't lost anything". In fact my plan will decrease the leverage after the market has gone down, and increase the leverage while the market is going up. If you look at the flow chart, you will see that I'll always try to roll over to a new strike that's half of the underlying asset price. This means the leverage level get reset back to 2:1 each time the option is rolled over. Since this is a strategy to "buy high and sell low", it certainly will not maintain my exposure, and after the recovery there is a big chance I would have lost money. However, if the market is going up year after year, this strategy will also return more than twice of the underlying asset's return. One thing I know for sure, there's more years the market was up than it was down, and it's very likely to remain this way.

    The comparison should always be with just buying the underlying (S&P 500), and if you did that, during a crash all your new money would be used to buy more of the underlying at "for sale" prices.
    Originally posted by under western skies
    Buy the "for sale" underlying asset after a crash will only work if it remains "for sale" for long enough while I'm waiting for my payday.

    With your options strategy, you instead have to use some or all of your new money to maintain your current exposure; so there is an opportunity cost. You are effectively trying to cover up the fact that your existing position in options is losing money by mixing it with the new money.
    Originally posted by under western skies
    Actually, my plan is to reduce the leverage (roll to a lower strike) after a market downturn. This way I can survive a long lasting bear market. If my intention is to maintain the same exposure, I won't need much new money anyway, because the cost of roll over to the same strike in a later date isn't going to be high. Maintaining the same exposure is only a compromise if I must roll before the expiry and don't have enough spare cash to deleverage.

    The more clear-sighted way to look at it is to separate (logically, not operationally) the handling of new money and roll overs. When you look at it like this, you have 2 choices when it's time to roll over an option that's losing money: keep to your target leverage (by reducing exposure) or maintain exposure (by increasing leverage). (Except that, in extreme cases, the latter may not be possible.) That's the choice to consider.
    Originally posted by under western skies
    My choice is clear, I will keep the target leverage. I will only maintain the exposure if I have no other choices.

    In the event that I had no option but to keep the exposure, the possibility of market not going up at all in 2 years (LEAPS can last for 2.5 years) is slim. The chances are, as long as I don't put all eggs in one basket (one country, one sector, etc.), this isn't going to happen.

    The way your plan mixes old and new money has the effect that how aggressive you are depends on the relative sizes of the option positions already held and of the new money being added. When the new money is relatively large, compared to what's already invested, it is less aggressive, because the exposure the new money can buy, while sticking to the target leverage, would in most market conditions be enough to cancel out the reduction in exposure from rolling over losing contracts into reduced exposure to maintain target leverage. But as the invested capital becomes larger relative to new money, the new money can't paper over losses so easily, and you could easily start ramping up the leverage. So this strategy is more likely to blow up badly after it's been going for some years. (Did you know that? If not, that's why you should have been modelling it.)
    Originally posted by under western skies
    That's the next part of the plan, which isn't relevant yet. But since you've asked, I'll answer. By the time the portfolio is big enough, I will be able to sell some contracts to fund the roll if it's necessary.

    Remember it? I intend to keep the leverage ratio at 2:1, therefore I'd have to reduce my exposure after a crash. Right now, my money can only buy me very few contracts, it's not economical to sell 3 and buy 2 contracts and end up with a lots of spare cash, therefore use my income to fund the roll is better. But when I have more invested, sell some contracts to fund the roll of others will become practical. Not only the proceeds from selling can be used to fund the cost of roll over, sell some contracts would also naturally reduce the leverage.

    Of course, the sell will only happen when the market is down. Under good market conditions, the underlying asset price goes up, the leverage ratio would have gone down. The roll over will increase the leverage back to 2:1 and release some cash from the old contracts. The cash will be used to fund the cost of the roll. Cash from income will also be used to fund the roll if the market didn't go up enough. Ended up with spare cash? No problem, just buy more shares or option contracts.

    Is there any sense a strategy becoming more aggressive as you have more invested (relative to the size of new cash)? I don't think so. This is another reason to separate (logically) the handing of roll overs and new cash. I.e. to have a rule about how to handle roll overs which doesn't refer to what new money is available.

    The more aggressive approach, of always maintaining exposure (if at all possible), is IMHO pretty mad if you attempt to follow it with no limit. Ultimately, you could end up buying far out-of-the-money options, waiting until they have nearly expired, still far out-of-the-money, and having lost most of their value when you bought them, and then reinvest the dwindling proceeds into new, longer-term, out-of-the-money options. Does that make any sense? If not, where do you stop?
    Originally posted by under western skies
    I know too well that maintaining exposure will kill me. I wouldn't touch it.

    In your plan as stated, there is no stopping digging when you're in a hole. (There is only a variable level of aggressiveness, increasing as you have more capital invested.)
    Originally posted by under western skies
    By keep the leverage ratio at 2:1, I don't see the need of a stopping point. A well diversified portfolio isn't going to fall 50% and then stays below 50% of the recent peak for years. Ironically, this strategy will actually benefit more from a slow recovery process spanning multiple years than a quick recover jump back to the pre-crash level.

    I think any experienced trader (which I'm not — I just know enough to know I shouldn't be trading) will say there is a point where you have to back off and reduce exposure. You can't sanely always keep doubling down. (It's an appropriate thread title.)
    Originally posted by under western skies
    I'm not an experienced trader. In fact I'm not even a trader. I hate trading, it benefits only the middleman. I make plans, and then execute them. Doubling down isn't a part of my plan.

    When considering how the effects of increasing leverage after a market fall, you'll note that (for instance) an at-the-money option is more expensive than a deep in-the-money option (for the same level of exposure), because the former is a 1-way bet, the latter a 2-way bet.
    Originally posted by under western skies
    This will not happen in an efficient market, because one can arbitrage by buying the cheaper ITM option and selling the more expensive ATM option, make a risk free profit equal to the difference between the premiums plus the different between the strikes minus the bid-ask spread and commissions.

    And a slightly different point: previously, I said most years would be good for this strategy. I was thinking that most years have no big crash. However, even aside from crashes and extreme events, in a mild year, with low but positive returns for an underlying index, the returns from an option strategy will be lower than the index, and could be a small loss, due to the cost of rolling (e.g. selling a 24-month option to buy a 12-month option). This alone, given many are projecting low returns from equities going forward, is a pretty good reason not to buy options now, when you could just buy the underlying index instead.
    Originally posted by under western skies
    The good thing about an efficient market is that those factors are priced in the option's premium, therefore now options are cheaper than they were. (current IV is at very low point comparing to the IV in the past 20 years).
    • under western skies
    • By under western skies 14th Jan 20, 3:31 AM
    • 6 Posts
    • 4 Thanks
    under western skies
    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.

    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.)

    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.

    One thing I know for sure, there's more years the market was up than it was down, and it's very likely to remain this way.
    Originally posted by Mr.Saver
    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).

    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.)

    This will not happen in an efficient market, because one can arbitrage by buying the cheaper ITM option and selling the more expensive ATM option, make a risk free profit equal to the difference between the premiums plus the different between the strikes minus the bid-ask spread and commissions.
    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.

    The good thing about an efficient market is that those factors are priced in the option's premium, therefore now options are cheaper than they were. (current IV is at very low point comparing to the IV in the past 20 years).
    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? 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.

    (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.
    Last edited by under western skies; 14-01-2020 at 3:43 AM.
    • Jonathan Kelvin
    • By Jonathan Kelvin 14th Jan 20, 7:03 AM
    • 219 Posts
    • 497 Thanks
    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?
    Last edited by Jonathan Kelvin; 14-01-2020 at 7:07 AM.
    • Mr.Saver
    • By Mr.Saver 14th Jan 20, 10:04 PM
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    Mr.Saver
    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?
    Originally posted by Jonathan Kelvin
    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
    • By Mr.Saver 15th Jan 20, 12:09 AM
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    Mr.Saver
    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.
    Originally posted by under western skies
    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.

    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.)
    Originally posted by under western skies
    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.


    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.
    Originally posted by under western skies
    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
    • By bowlhead99 15th Jan 20, 7:27 AM
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    bowlhead99

    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.
    Originally posted by Mr.Saver
    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
    • By Thrugelmir 15th Jan 20, 1:01 PM
    • 66,351 Posts
    • 58,409 Thanks
    Thrugelmir
    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.
    Originally posted by Mr.Saver
    Markets can stay irrational longer than investors can remain solvent.
    “Risk comes from not knowing what you are doing. – Warren Buffett”
    • Malthusian
    • By Malthusian 15th Jan 20, 4:17 PM
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    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
    • By Mr.Saver 15th Jan 20, 7:17 PM
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    • 172 Thanks
    Mr.Saver
    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).
    Originally posted by under western skies
    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.

    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.)
    Originally posted by under western skies
    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.

    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.
    Originally posted by under western skies
    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.

    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?
    Originally posted by under western skies
    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.

    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.
    Originally posted by under western skies
    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.

    (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.
    Originally posted by under western skies
    Thank you. Your comments gave me more things to think about.
    • Mr.Saver
    • By Mr.Saver 15th Jan 20, 8:01 PM
    • 353 Posts
    • 172 Thanks
    Mr.Saver
    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.
    Originally posted by bowlhead99
    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
    • By Mr.Saver 15th Jan 20, 10:19 PM
    • 353 Posts
    • 172 Thanks
    Mr.Saver
    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.
    Originally posted by Malthusian
    Very interesting reading, I've managed to kill 3 hours time on that, and will continue tomorrow.
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