Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

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Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby marketeer » Thu May 09, 2013 10:56 pm

[Originally posted in Ayres and Nalebuff: Young people should buy stocks on margin, moved into separate thread. --admin LadyGeek]

I've been using this strategy (roughly) for the last year and a half to two years. It has been a propitious time for it. Started quite small, but now I have a pretty large Interactive Brokers margin account leveraging up SPY and VTI a bit less than 2:1. With the account balance and the market getting higher, I'm more and more concerned about the risks I don't have a good understanding for, however.

Questions for the board:

1) Would a "flash crash" of the type experienced in May 2010 be likely to wipe an account like this out? I'm concerned because VTI was momentarily down >50%, which could trigger a margin call and automatic liquidation of the entire position. I don't know whether a few crazy trades are enough to trigger a margin call or liquidation, or what the shares would wind up being sold at, but to me this is a grave concern, much more so than a traditional overnight market drop. (Shouldn't everyone long on equities on margin at IB be worried about this?) If I were to continue to use margin, are there any reasonable strategies I could use to reduce this risk? (Portfolio margin, hedging, or an alternative broker are the only things that come to mind)

2) Of the alternative leverage strategies (SPDR options, leveraged ETFs), is there a decent option? Why would one choose them? SPDR options used for leverage seem to have an implied cost of 3-5% (from the book) if you consider the loss of dividend income. Given that that's a very high bar to reach - much higher than IB's 1.7% or a leveraged ETF's 1-2%, why would one even consider them?

Daily rebalanced leveraged ETFs have a lot of problems associated with the rebalancing frequency when held for long periods. While there are monthly rebalancing ETFs, they have a higher cost, and I've read some journal articles indicating that in the long run their returns are similar to daily. Why are the authors worried about the 1-2% costs of these ETFs, given the higher costs of the alternatives? Would it be worth looking into "self-rebalancing" a daily rebalancing 2x fund with a strategy like this? http://www.proshares.com/resources/tool ... tions.html

Interested in your thoughts and recommendations. I've considered selling out of this strategy entirely, but I'd like to ensure I have a good understanding of it first. Thanks...
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby Snowjob » Fri May 10, 2013 7:34 pm

2 points

Point 1: My experience with interactive brokers margin calls were I got an email 10 min before the end of the trading day saying I was in violation of my margin requirements and needed to raise cash. I didn't realize the email came in and they sold down a position for me to get my account into compliance.

Point 2: I never intended to get to such a highly leveraged position I actually had [messed up --admin LadyGeek] a large sell order and it never processed during the day. Ended up not being a big deal but I try not to over lever. At these market conditions I would humbly advise that you book some of those gains and reduce leverage, its not much fun on the way down, I can attest to that as can a few others here. (Read Market Timer's thread if your interested on such things)

Edit* Point 3: Avoid leveraged ETF's unless you are a day trader and know what you are doing.
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby clacy » Fri May 10, 2013 8:00 pm

I would say the best time to lever up obviously was 3-4 years ago.

I would be inclined to de-lever, put at least 20-30%+ in short term bonds, and then go back in with leverage after the next 30% draw down.

It's possible that you wouldn't be able to lever up for quite some time (years possibly), but that certainly wouldn't be the worst thing in the world, as it would mean your remaining stock position would be doing very well.
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby nisiprius » Fri May 10, 2013 8:14 pm

Marketeer, aren't you familiar with our forum's "expert" on this strategy, Market Timer, and his long-running thread, A Different Approach to Asset Allocation?

He tried it.

He is a very smart guy with a lot of market savvy.

It did not turn out well.

Also, just to be perfectly clear: have you chapter six of the book, in which they say you should not try this strategy if any of these six conditions apply. Can you verify that none of them applies to you?
  • You have credit card debt.
  • You have less than $4,000 to invest.
  • Your employer matches contributions to a 401k plan.
  • You need the money to pay for your kids' college education.
  • Your salary is correlated with the market.
  • You would worry too much about losing money.
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby marketeer » Sat May 11, 2013 3:37 pm

I read most of that thread (noticed he was called out in the book) and another one on this board. My post was actually originally a reply to one of these threads. I'm definitely not being that aggressive... certainly not taking out credit card debt or anything other than the Reg T margin I have. I am following one of the methods from the book, and actually am currently only around 1.5 to 1 leveraged because I'm hesitant to buy more right now.

I have 0 credit card debt, plenty to invest, my employer matches contributions but I max out my and my wife's 401k in addition to backdoor Roth, HSA, tax-deductible contributions to 529, etc. I'm in some ways a good Boglehead and in other ways intrigued by Buffett-style value investing and Shiller's Irrational Exuberance/thoughts on bubbles (which is what led me to the Lifecycle Investing book). I'm always intrigued by the idea that it might be possible to beat the market in some underappreciated way, but when I don't feel like I have any special insight I default to Bogle strategies (buying the lowest cost index funds and lowering tax exposure). It's very hard to say whether my salary is correlated with the market... it was not during the last recession but may be during the next. And while I like to think I'm unworried about losing money, I realize it takes some serious, well, guts to stomach a stock fall like the one we had from 2008. My hope is that Shiller-style adjustments would help mitigate that. But I'm not willing to take the risk of a momentary intraday flash crash wiping out my account if that is a realistic possibility.

Do any of the alternative strategies (SPDR options, leveraged ETFs) make sense to you? Are there some other reasons to be hesitant about the margin strategy? If a leveraged ETF were to rebalance its leverage quarterly rather than daily, would that make more sense? I feel like once I get over around 2.5% in costs, I have to question the benefit of leveraging up, especially in a market that's probably already getting overvalued.

nisiprius wrote:Marketeer, aren't you familiar with our forum's "expert" on this strategy, Market Timer, and his long-running thread, A Different Approach to Asset Allocation?
...
Also, just to be perfectly clear: have you chapter six of the book, in which they say you should not try this strategy if any of these six conditions apply. Can you verify that none of them applies to you?
  • You have credit card debt.
  • You have less than $4,000 to invest.
  • Your employer matches contributions to a 401k plan.
  • You need the money to pay for your kids' college education.
  • Your salary is correlated with the market.
  • You would worry too much about losing money.
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby nisiprius » Sat May 11, 2013 4:13 pm

Leveraged ETFS make no sense whatsoever, and the fact that Ayres and Nalebuff even mention using a similar product--ProFunds UltraBull, a 2X leveraged mutual fund--should make you skeptical about their other advice. Just take a look at the growth charts:

Image

At inception of UltraBull, if you'd invested $10,000 into this "2X S&P" fund and $10,000 into plain-jane Vanguard Index 500 Fund, today the Index 500 fund

--would have added on $12,000 in earnings,

while UltraBull added on,
--not 2X $12,000 = $24,000,
--not $24,000 less a few thousand due to 1.7%/year expenses(!), but...
----->$796 in earnings.

And there's no reason to be surprised at that, because the fund company itself says, their own words:
This ETF seeks a return of 200% of the return of an index (target) for a single day. Due to the compounding of daily returns, ProShares' returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. Investors should monitor their ProShares holdings consistent with their strategies, as frequently as daily.
I mean, how could they possibly be clearer? "This fund is not for buy-and-hold investors. This fund is for people who wish to place bets on on single-day movements of the S&P."

As for the new three-month leveraged ETFs, I don't know what the gotcha is, just as I don't know what's wrong with the "overunity" (perpetual motion) machines you can watch on YouTube. We know what the problems are with the existing leveraged ETFs are. So, someone has introduced new, twisteroo product that's just different enough that it's not clear what they are. It will probably take a sharp drop in the market to expose them. But, really. Do you honestly think that you can get the reward of 2X leverage without taking the risk of 2X leverage?
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby momar » Sat May 11, 2013 4:47 pm

I am just commenting to point out how similar the two user names are.
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby nisiprius » Sat May 11, 2013 4:55 pm

momar wrote:I am just commenting to point out how similar the two user names are.
Marketeer talks above about having read Market Timer's long-running thread. Unfortunately threads always show the user's current avatar, so Marketeer has only seen Market Timer's "Don Quixote" avatar, and did not see the rather alarming period of time during which Market Timer was using the image of Raskolnikov.
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby zotty » Sat May 11, 2013 5:12 pm

A big crash that closes way down will bankrupt you. That's how debt works.

It's somewhat unlikely, but not impossible.

A more likely scenario is a 6 week super bear. A 40% loss x2 is 80% loss. You'll be margin called somewhat before that position, but you shouldn't wait that long to act:

You must help yourself by establishing, in writing, a maximum tolerable loss, at which time you'll sell enough shares to cover your borrowed cost. A stop rule, in writing, that you'll be more than happy to obey.

I would set your stop rule HIGH. That is, a maximum portfolio loss of 10%, or something, that will force you to sell enough to cover your debts. If you let your losses mount up, you could be margined into bankruptcy.

It can happen fast, but usually you'll have a few days to act.

Basically, you must be prepared to sell when the market turns against you. This is the only sure fire way to avoid bankruptcy court.

That said, i don't think debt investing a very good idea. Stop rules lower your expected return on average. It's double fun on the way up, but it's double pain on the way down.

Frankly, i'd quit while i was ahead, keep your gains and move on to a less stressful strategy.
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby marketeer » Sat May 11, 2013 5:44 pm

momar wrote:I am just commenting to point out how similar the two user names are.


Ha. :) Not the same person, not a deliberate similarity. Was the first username that came to mind when signing up for a new account. I'm looking for some insights on the strategy that I didn't get out of the first thread, and I'm ok if the price of being well informed is looking a little naive or stupid.

I think I agree with nisiprius that it makes no sense to buy and hold a 2x daily rebalancing fund, for the reason that i suspect that daily leverage rebalancing kills you in even typical volatility. Similarly, if I balanced leverage every day in my margin account I would experience the same issue.

However I am not sure that there is much difference, other than margin calls and maximum losses, between, say, putting 100k on 2:1 margin at 1.7% and rebalancing your leverage monthly, and buying 100k of a monthly rebalanced 2x ETF with a 1.7% expense ratio. In that sense I don't see a reason to believe that the ETF is innately worse. The rebalancing period is the issue.
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby boggler » Sat May 11, 2013 6:10 pm

marketeer wrote:
momar wrote:I am just commenting to point out how similar the two user names are.


Ha. :) Not the same person, not a deliberate similarity. Was the first username that came to mind when signing up for a new account. I'm looking for some insights on the strategy that I didn't get out of the first thread, and I'm ok if the price of being well informed is looking a little naive or stupid.

I think I agree with nisiprius that it makes no sense to buy and hold a 2x daily rebalancing fund, for the reason that i suspect that daily leverage rebalancing kills you in even typical volatility. Similarly, if I balanced leverage every day in my margin account I would experience the same issue.

However I am not sure that there is much difference, other than margin calls and maximum losses, between, say, putting 100k on 2:1 margin at 1.7% and rebalancing your leverage monthly, and buying 100k of a monthly rebalanced 2x ETF with a 1.7% expense ratio. In that sense I don't see a reason to believe that the ETF is innately worse. The rebalancing period is the issue.


I considered this a while ago with a few posts on this forum. Still contemplating it, but I haven't had time to look into it more. You might consider leveraged ETNs, as most of these don't have the daily rebalancing problem, with the leverage being set at the inception of the ETN. They do have credit risk, though.

I do recall thinking that the best option was to simply use IB margin, but I was equally spooked about the possibility of a margin call. One option might be to leverage Vanguard mutual funds rather than the ETFs. Since the pricing is done at the end of the day, flash crashes won't be an issue.
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby Ranger » Sat May 11, 2013 6:56 pm

1) Would a "flash crash" of the type experienced in May 2010 be likely to wipe an account like this out? I'm concerned because VTI was momentarily down >50%, which could trigger a margin call and automatic liquidation of the entire position. I don't know whether a few crazy trades are enough to trigger a margin call or liquidation, or what the shares would wind up being sold at, but to me this is a grave concern,


Are you concerned about drawdown or concerned about liquidation due to flash crash?

If you are in Portfolio Margin account at Interactive Brokers, you are leverage is close to 1:6 for regular equities or for the products you are using (SPY, VTI) leverage is closer to 1:8. In the event of flash crash, there won't be margin call in Portfolio Margin account if the draw down is 50%

If I were to continue to use margin, are there any reasonable strategies I could use to reduce this risk?


Reasonable strategies to use, if you think the markets are over-valued:

1) Reducing equity exposure
2) Using options strategies like buying puts and using collars or
3) Shorting 30 to 40% equivalent portfolio deltas using E-mini futures. You should be prudent to lift your hedges, when the markets at reasonable valuation from your perspective

SPDR options used for leverage seem to have an implied cost of 3-5% (from the book)


Book must be written in the era, when the interest were normal. Approximate rate for implied cost is equivalent to 3 month treasury rate. You can calculate using put-call parity. For E-mini futures implied cost rate is about 50 basis points

http://www.cmegroup.com/trading/equity- ... /main.html

One thing for sure, Leveraged ETF's are not the way to go for long term hedging.

Regarding Market-timer thread, take it with grain of salt. It is sample size of 1. If I post the similar thread with outsized returns using derivatives, it will be dismissed as lucky.

Good luck
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby Calm Man » Sat May 11, 2013 7:17 pm

OP, there is a simple rule that you could adopt and then not have to think about any of these things. Never use margin. Never. A second rule is never used leveraged anything.
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby marketeer » Sat May 11, 2013 8:09 pm

boggler wrote: One option might be to leverage Vanguard mutual funds rather than the ETFs. Since the pricing is done at the end of the day, flash crashes won't be an issue.


I thought of this too. Unfortunately, you can't leverage mutual funds. Will look into what you're saying with ETNs, although if you mean that the leverage is set one time and never rebalanced that sounds like a problem too.

Ranger wrote: If you are in Portfolio Margin account at Interactive Brokers, you are leverage is close to 1:6 for regular equities or for the products you are using (SPY, VTI) leverage is closer to 1:8. In the event of flash crash, there won't be margin call in Portfolio Margin account if the draw down is 50%


So right now I'm in a Reg T account. I've considered going to Portfolio for this very reason (I have no desire to leverage up to crazy ratios, but I DO want to avoid a margin call if something crazy happens. I figure this gives me more leeway). Do you know if you get these 1:6 (~15%) rates with just 1 or 2 ETFs (and no hedge) in the portfolio, or do you get penalized by IB for a concentrated position?

Still unless I'm missing something (thinking through this quickly): If you put $100K in an account and you leverage it up 2:1, you have (-100K cash, $200K stock) for $100K net. Your leverage ratio is $200K stock:$100K net = 2:1. If the market drops 50% suddenly, you have (-$100K cash, +$100K stock) for $0K net. Your leverage ratio is $100K stock:$0K net = infinite. You will get a margin call in that case in Portfolio Margin just as you will in Reg T, and if the liquidation is at the -50% price your account will be completely wiped out. The diff between Reg T and portfolio margin at 2:1 is something like the difference between getting a margin call when the market is down 33% (Reg T) and something closer to 40% (portfolio). Am I wrong?

For the implied costs are you factoring in loss of dividends? Because if you own SPY in a margin account you get dividends. If you own SPDR options you don't. Will check out the linked site.

Calm Man wrote:OP, there is a simple rule that you could adopt and then not have to think about any of these things. Never use margin. Never. A second rule is never used leveraged anything.

Much smarter people than myself have said the same thing :) I wouldn't mind hearing more of their reasoning, however...
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby Wolkenspiel » Sat May 11, 2013 8:13 pm

Unlike most everybody else here, I don't necessarily feel that a moderate amount of leverage spells certain doom. My criterion for "moderate" is that one's portfolio should be able to make it through a repeat of the 2007-2012 period without blowing up, even if you don't take bold and correctly timed steps. Market Timers portfolio clearly failed the test. Heavy use of leveraged ETFs would have failed the test (requiring to rebalance into the falling ETF to maintain constant exposure). 1.5x leverage with IB Reg-T margin seems to be cutting it a bit close. I would not feel comfortable with that unless I had a clear plan on how to react to a nightmare scenario of rising rates and simultaneous 2008-style market decline.

My use of leverage relies mostly on the proceeds of some low-fixed rate loans (e.g. PenFed 1.5x% car loans, 0% credit card) + a little bit of IB margin + some leveraged ETFs ( :P ), most of which will unwind itself over the next years without any clever decisions/actions by me. For full disclosure, I'm tenured faculty at a rich private university (i.e. it would require a major faux pas on my side to get fired), with a typical retirement age among my colleagues of 75 or so.
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby marketeer » Sat May 11, 2013 9:10 pm

So it's hard to design a portfolio with leverage that would not have had some serious issues from 2007-2012. http://www.frbatlanta.org/cenfis/pubscf ... crisis.cfm After all, an unleveraged portfolio had serious issues. For most people, a 50% drop isn't all right. At least it would recover eventually. A leveraged portfolio would likely have to rebalance to stay solvent.

Having been through two serious (and in my mind highly obvious) bubbles followed by downturns (tech stocks, real estate) I've become a big fan of Robert Shiller's work - I read Irrational Exuberance and closely followed the Case Shiller indices. Always especially liked this chart: http://en.wikipedia.org/wiki/File:Price-Earnings_Ratios_as_a_Predictor_of_Twenty-Year_Returns_(Shiller_Data).png

I noticed that the Lifecycle Investing authors incorporated Shiller's material somewhat, which made sense to me. At a higher P/E10, a lower share of future earnings should be currently exposed to the market. The implication from the book if I remember correctly was that around a P/E10 of 26.something, no equity should be exposed to the market (because expected real returns were negative - which makes sense from that chart). So even following the book's advice I would expect to wind down leverage significantly soon anyway - maybe even exit SPY entirely and move toward bonds - given current upward market trends. Current P/E10 is in the 22's, possibly 23's, according to Shiller's data. Yes I know all this is sacrilege to Bogleheads (now I'm introducing market timing!).

Wolkenspiel wrote:Unlike most everybody else here, I don't necessarily feel that a moderate amount of leverage spells certain doom. My criterion for "moderate" is that one's portfolio should be able to make it through a repeat of the 2007-2012 period without blowing up, even if you don't take bold and correctly timed steps. Market Timers portfolio clearly failed the test. Heavy use of leveraged ETFs would have failed the test (requiring to rebalance into the falling ETF to maintain constant exposure). 1.5x leverage with IB Reg-T margin seems to be cutting it a bit close. I would not feel comfortable with that unless I had a clear plan on how to react to a nightmare scenario of rising rates and simultaneous 2008-style market decline.
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby Bill Bernstein » Sat May 11, 2013 9:25 pm

In fairness to Nalebuff and Ayres, their preferred strategy is the purchase of deep in the money LEAPS, which merely become essentially worthless with a >50% market fall, but don't trigger margin calls.

Theoretically, it works, and I'm impressed with their numbers. There are 2 huge problems with it:

1) It's underdiversified, since long-dated LEAPS outside big US stock indexes are illiquid, and
2) The strategy is not executable by normal human beings. (I.e., 95% of investors, this one included, don't do well long-term with 100% stocks. 200% is way over the edge for anyone but R2D2.)

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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby Ranger » Sat May 11, 2013 9:55 pm

Do you know if you get these 1:6 (~15%) rates with just 1 or 2 ETFs (and no hedge) in the portfolio, or do you get penalized by IB for a concentrated position?


For concentrated portfolio with regular equities, margin goes up from 15% to 30% (1:3.33). If it is pure SPY position, probably it goes from 8% to 16%. You can call them to clarify.


You are right about 50% draw-down and its effect on PM. But since you are worried about flash crash, fully margined PM can survive flash crash, since the circuit breaker kicks in at 10%. 20% and 30% drop of the market.

For the implied costs are you factoring in loss of dividends? Because if you own SPY in a margin account you get dividends. If you own SPDR options you don't.


Implied financing costs factors only interest rate. But if you own SPY and hedging with option, dividends are still paid until it will be put to the put writer at the strike price. Are you planning this with Long LEAPS? If so, then dividends won't be paid.
Edit: Even tho' dividends are not paid, when you model the option you do consider the dividend rate in pricing of the option. Only time you get penalized, is when dividend is changed from its current rate during the life of the option.
Check out this thread also:
viewtopic.php?f=10&t=111947&p=1630086#p1630086
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby market timer » Sat May 11, 2013 10:13 pm

As Ranger notes, the implicit financing costs of LEAPS are tied to interest rates. In the current environment, where interest rates are well below the dividend yield on SPY, there really isn't a market for long term call options on the stock market (typical deep-in-the-money 2015 call options should be exercised just prior to the next ex-div date). One alternative to consider is buying broad market ETFs on margin and far out of the money, long dated puts as insurance against drawdown.
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby marketeer » Sat May 11, 2013 11:04 pm

Ranger wrote:You are right about 50% draw-down and its effect on PM. But since you are worried about flash crash, fully margined PM can survive flash crash, since the circuit breaker kicks in at 10%. 20% and 30% drop of the market.


Tell me what you mean by circuit breaker. Do you mean the NYSE circuit breaker that's triggered on drops of the Dow? (problem with this is an ETF can trade at an unrelated value, and VTI actually was down ~50% intraday on May 6, 2010: http://d0j.blogspot.com/2010/05/monenta ... -2010.html - not sure whether this would trigger IB autoliquidation or whether the position would sell at that value, but you get the concern)

Or do you mean an IB circuit breaker particular to portfolio margin/autoliquidation? (if it's related to PM, I'm unaware of it because I haven't used PM yet, but I'm very, very interested!)
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby zotty » Sat May 11, 2013 11:39 pm

wbern wrote:In fairness to Nalebuff and Ayres, their preferred strategy is the purchase of deep in the money LEAPS, which merely become essentially worthless with a >50% market fall, but don't trigger margin calls.


I can't understand why anyone sees any value in long dated options. Maybe I'm looking at the wrong product. I keep reading that the time value is relatively flat until 6 months prior to expiration, yet my calculator shows something entirely different when i price them. Big time decay across the entire time spectrum. I think it would be a lot cheaper and more effective to borrow and use a stop loss. Better still, don't borrow at all.
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby boggler » Sun May 12, 2013 2:28 am

marketeer wrote:
boggler wrote: One option might be to leverage Vanguard mutual funds rather than the ETFs. Since the pricing is done at the end of the day, flash crashes won't be an issue.


I thought of this too. Unfortunately, you can't leverage mutual funds. Will look into what you're saying with ETNs, although if you mean that the leverage is set one time and never rebalanced that sounds like a problem too.


I believe you can after 30 days. What did you see?
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby Ranger » Sun May 12, 2013 7:03 am

Tell me what you mean by circuit breaker. Do you mean the NYSE circuit breaker that's triggered on drops of the Dow?


Yes. SEC has new rules now as of Feb 2013. It is based on SP500 now. New triggers are 7%,13% and 20% based on previous day close (instead of 10%,20% and 30% of Dow based on previous qtr).
http://www.sec.gov/investor/alerts/circ ... lletin.htm

problem with this is an ETF can trade at an unrelated value, and VTI actually was down ~50% intraday on May 6, 2010: http://d0j.blogspot.com/2010/05/monenta ... -2010.html



I do remember that day vividly (I am an short term derivatives trader). But again with new rules of "New Limit Up-Limit Down Mechanism" which was not there before flash crash, Liquid ETF should not move that much from intrinsic value.

I am not a big fan of these other ETF's other than SPY,QQQ,IWM and EEM. These ETF's have very liquid, liquid underlying's, penny wide options to hedge. VTI does not fit that bill. SPY was down around 10%, where as VTI was close to 50% during flash crash.

IB does have color coded signal warnings, when the margin deficiency is close to 5%, but unless you are an active trader and watch their TWS you will miss it.

Options get bad rep in this forum. There is no other instrument better suited (including long stock) for these situations than risk bound techniques of Options.
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby Calm Man » Sun May 12, 2013 7:18 am

marketeer wrote:
boggler wrote: One option might be to leverage Vanguard mutual funds rather than the ETFs. Since the pricing is done at the end of the day, flash crashes won't be an issue.


I thought of this too. Unfortunately, you can't leverage mutual funds. Will look into what you're saying with ETNs, although if you mean that the leverage is set one time and never rebalanced that sounds like a problem too.

Ranger wrote: If you are in Portfolio Margin account at Interactive Brokers, you are leverage is close to 1:6 for regular equities or for the products you are using (SPY, VTI) leverage is closer to 1:8. In the event of flash crash, there won't be margin call in Portfolio Margin account if the draw down is 50%


So right now I'm in a Reg T account. I've considered going to Portfolio for this very reason (I have no desire to leverage up to crazy ratios, but I DO want to avoid a margin call if something crazy happens. I figure this gives me more leeway). Do you know if you get these 1:6 (~15%) rates with just 1 or 2 ETFs (and no hedge) in the portfolio, or do you get penalized by IB for a concentrated position?

Still unless I'm missing something (thinking through this quickly): If you put $100K in an account and you leverage it up 2:1, you have (-100K cash, $200K stock) for $100K net. Your leverage ratio is $200K stock:$100K net = 2:1. If the market drops 50% suddenly, you have (-$100K cash, +$100K stock) for $0K net. Your leverage ratio is $100K stock:$0K net = infinite. You will get a margin call in that case in Portfolio Margin just as you will in Reg T, and if the liquidation is at the -50% price your account will be completely wiped out. The diff between Reg T and portfolio margin at 2:1 is something like the difference between getting a margin call when the market is down 33% (Reg T) and something closer to 40% (portfolio). Am I wrong?

For the implied costs are you factoring in loss of dividends? Because if you own SPY in a margin account you get dividends. If you own SPDR options you don't. Will check out the linked site.

Calm Man wrote:OP, there is a simple rule that you could adopt and then not have to think about any of these things. Never use margin. Never. A second rule is never used leveraged anything.

Much smarter people than myself have said the same thing :) I wouldn't mind hearing more of their reasoning, however...


I can't give you their reasons, only mine. With margin, you increase your chance of catastrophe where it otherwise need not happen. And even if you are content to wait it out, the brokerage firm will sell out your position at the worse time. For leverage, well with ETFs, leveraged ETFs are only short-term, e.g. daily, trading vehicles. Small investors cannot beat the big boys at trading.
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby Park » Sun May 12, 2013 9:50 am

Ranger wrote:Options get bad rep in this forum. There is no other instrument better suited (including long stock) for these situations than risk bound techniques of Options.


I agree with you Ranger: derivatives can play a useful role in a portfolio. But it sounds like you're a professional trader. More than 95% of us in this forum are retail investors who dabble no more than a few hours a week. Under those circumstances, it is wise to stay away from derivatives.

FWIW, I wouldn't be enthusiastic about levering the US stock market at the present time; valuations are on the high side. With that statement, I am guilty of market timing.
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby marketeer » Sun May 12, 2013 9:05 pm

Ranger wrote:I do remember that day vividly (I am an short term derivatives trader). But again with new rules of "New Limit Up-Limit Down Mechanism" which was not there before flash crash, Liquid ETF should not move that much from intrinsic value.

I am not a big fan of these other ETF's other than SPY,QQQ,IWM and EEM. These ETF's have very liquid, liquid underlying's, penny wide options to hedge. VTI does not fit that bill. SPY was down around 10%, where as VTI was close to 50% during flash crash.
...
Options get bad rep in this forum. There is no other instrument better suited (including long stock) for these situations than risk bound techniques of Options.


Thanks. This is good info. It sounds like LULD is very new and may help with exactly this sort of situation, although I don't have complete clarity on how it affects ETFs. http://www.theetfbully.com/2011/05/will ... ker-rules/

It sounds also like a more liquid ETF has some advantages over a less liquid ETF in the case of a flash crash.

Some practical tweaks that I could make in the short term are to replace my VTI with SPY and to switch to portfolio margin. I will look into the options side of things as well... I'm familiar with the basic principles but, other than employee stock options, I haven't dealt a lot with trading options. How would you you think about this in terms of structuring as an options trade? Thanks!
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby marketeer » Sun May 12, 2013 9:49 pm

boggler wrote:
marketeer wrote:
boggler wrote: One option might be to leverage Vanguard mutual funds rather than the ETFs. Since the pricing is done at the end of the day, flash crashes won't be an issue.


I thought of this too. Unfortunately, you can't leverage mutual funds. Will look into what you're saying with ETNs, although if you mean that the leverage is set one time and never rebalanced that sounds like a problem too.


I believe you can after 30 days. What did you see?


Are you asking about mutual funds on margin, or ETN rebalancing?

On margin... http://ibkb.interactivebrokers.com/article/711 Interesting wording... it looks like although you cannot purchase a mutual fund on margin, you can use its collateral value after 30 days to purchase, say, stocks on margin. So if you had $100K cash in a margin account, you couldn't use it to purchase $200K of a mutual fund, because that would clearly be buying a mutual fund on margin. Yet perhaps you could use it to purchase $100K of a mutual fund, and then use that mutual fund equity's value as collateral to purchase $100k of an ETF? Anyway, given what I'm trying to do, that probably complicates things.

In terms of leverage rebalancing, I think there are ETNs that rebalance daily, monthly, and not at all. The "not at all" thing appears to be specific to ETNs. http://etfdb.com/2011/inside-the-8x-leveraged-etn/ Daily and monthly are available in ETFs.

However you do this strategy (with margin, options, or leveraged ETxs) the leverage rebalancing frequency is very important. A few different pieces of research I've seen indicate that daily and monthly rebalancing have very similar long-term returns, for example http://www.aabri.com/manuscripts/10676.pdf My gut says that daily and monthly are both too frequent. The book seems to recommend quarterly or when the market moves 10%. I don't believe there is an S&P 500 ETx that rebalances quarterly, but I would be interested if there were one.

Not rebalancing leverage at all is somewhat interesting. Perhaps in some ways it could accomplish some goals that the Lifecycle Investing authors are articulating (decrease leverage as you get older, decrease leverage as the market gets more overvalued). In a big downturn it would increase the odds of recovering everything as well as losing everything.
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby Park » Sun May 12, 2013 11:48 pm

When one rebalances between stocks and bonds, one tends to buy low and sell high. Leverage is akin to negative bonds, and things work in reverse. When you're levered and you rebalance, you tend to buy high and sell low.

Others, besides Ayres and Nalebuff, have written books about levered indexing. One previously mentioned example is Moshe Milevsky. Michael Edesess and Jeremy Siegel have brief sections about it. I believe that Siegel has advocated it for the aggressive investor going back to the first edition of his book in 1994. However, Siegel doesn't advocate more than 139% leverage. Tristan Yates wrote a book about using options to lever index investing.
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby Ranger » Mon May 13, 2013 6:51 pm

marketeer wrote: How would you you think about this in terms of structuring as an options trade? Thanks!


I haven’t read the book you posted. Does the book give any suggestions to implement it?
You can go thru’ Market-timer thread. I read that thread long time back. Don’t remember all the details about implementation.
Also, several have raised concern about implementing leverage, when the markets are at historic high. I tend to agree with them.

In Your original post you wanted to know about implementing leverage, but concerned about
1) Flash crash
2) Current Valuation (High valuation and implementing leverage does not go together)
3) Dividends (do you need income?)
4) Rebalancing strategy?

Also, do you already have some position? are you concerned about tax consequences if you liquidate them?

There are millions way of implementing option strategy. It is based on your risk tolerance and the concerns you wanted to address.

a) Easiest way to implement is buy a Long deep in the money call. It address your concern 1), but Long call does not have any dividend and you loose all your money if index goes below your strike price. Personally I never buy any naked call or puts (unless i am gamma scalping). Position looses when index declines or stagnant (2 out of 3 possibilities)

b) Buy SPY on margin and buy puts to protect it. Most people prefer this, puts are cheap in this low vol. environment. Again it looses 2 out of 3 possibilities, but losses will be small compared to case a), also needs lot more capital. (But as an primarily premium seller myself, i don't like it). It addresses your concern 1), 2) and 3).

c) You could buy SPY on margin and use collar option strategy. For ex. Today's SPY closed at 163.54. You could buy 130 Mar 2014 (One Standard deviation away) put for $2.08 and sell 180 Mar 2014 call (again One std. deviation away) for $2.10. After commissions this collar costs nothing. This address your concern 1) and to some extent concern 2) and you receive dividends. But again if SPY goes above $180 about 10% from here (20% profit), your position will be called away. Your losses will be capped at 20% (40% if on margin). You can move your put strike up, but you have to pay for it.

d) Buy SPY, but if SPY falls below certain point then short SP500 index futures to neutralize certain amount of portfolio delta's. This strategy costs the least, but needs lots of monitoring to put the hedge and to lift the hedge.

e) personally if I were to implement this strategy, worried about valuation and i am willing to buy at lower prices, then I would buy vertical bull call spread and sell lower put to finance it. For example I would buy Vertical call spread 165-177 (buy Mar 14 165 call sell Mar 14 177 call spread) and sell Mar 14 sell 146 put for zero cost. If the index goes up, I make money, if it stagnates or index looses less than 10%, then I don't loose anything. But if the stock is put to me @ 146, i am ok with it, when SPY is at 146. Max profit on 10 SPY contracts is about $12,000, it needs buying power of only $8,300.
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby marketeer » Thu May 16, 2013 12:50 pm

Thanks for all the replies. What I've done recently is sell off my VTI holding and move to portfolio margin. The portfolio margin threshold I got with SPY was 8%, which is a lot better than the 25% I got with Reg T. At 8% I could theoretically leverage up to 12.5:1 (I don't want to): this gives me protection from a margin call as long as the index does not fall 45% from a 2:1 leveraged start (as opposed to 33% with Reg T).

I feel also by sticking with SPY instead of VTI there is more liquidity in the event of a flash crash, and it sounds like there are more controls in place to prevent that now than there were in 2010.

I haven't replaced my VTI position, meaning I deleveraged to about 1.3:1. The market P/E10 is getting high, and my target Shiller PE-adjusted exposure to the market is only a little over what I have saved already, so lowering leverage now seems prudent.

I am in the process of checking out the options methodology in the book and looking at investment alternatives in case I want to fully deleverage and not be 100% in equities.
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby marketeer » Thu May 16, 2013 10:37 pm

So the book recommends buying 2-year LEAP calls with a strike price of roughly half the current SPY price. This is Ayres and Nalebuff's preferred strategy, with margin a close second. I'm confused why LEAPS are recommended at all, though.

1. SPY is currently priced around 165. A 2-year LEAPS call with a strike around 80 is priced around 85... so superficially the cost of the ~2x leverage is very close to 0 (80+85 = 165), compared to the margin strategy (buy SPY on margin) cost of 1.2-1.7% from IB. But... if you buy SPY on margin you get dividends on SPY. If you buy a SPDR option and hold it to expiration you miss out on the dividends! This is a big loss. I did the calculation here: http://www.lifecycleinvesting.net/resources.html (Calculate the implied interest on a SPDR option contract) and it's effectively a ~4% annual cost right now. I suppose in the future margin interest may have a lot worse rates, in which case this might be competitive.

Currrent level of SPDR: 165.34
Strike price of option: 80.00
Price of option: 85.41
Annual S&P dividends/share divided by 10: 3.21
Days till expiration: 946
Transaction cost/share: 0.30
Total: 4.03%

2. It looks like there is a large bid/ask spread and not a lot of liquidity on many of these LEAPS calls - think that was mentioned before in this thread.

3. While there is a benefit to avoiding margin calls, it's not huge. With portfolio margin you get to go 45% down from 2:1 without rebalancing and with no timeframe. You can rebalance fairly easily on your own timeframe. With these options, if stocks fall just a bit more than that and your option expires (2-year window) your investment will be worthless.

4. It is not completely clear from the book whether you're supposed to hold the option to expiration.
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby marketeer » Sat May 25, 2013 9:00 am

So any comments? What I'm interested in is why anyone would bother trading LEAPs, at least since the time the book was written, to follow the Lifecycle Investing strategy, given that:

- its implied cost is around 4%, when you consider loss of dividends
- you can get margin at 1.something %

Is the answer that you can do it in a retirement account? (clear advantage) That you avoid margin calls? (I think this is a small advantage) Anything else?
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Re: Using Ayres/Nalebuff leveraged strategy (Lifecycle Inv.)

Postby Ranger » Sat May 25, 2013 10:02 am

Your assumption of implied cost of 4%, due to loss of dividends is wrong. I already wrote above dividends are taken into account during calculation of option pricing.

You can also use CBOE or any option calculator to figure out this. Here is the theoretical option price from CBOE calculator based on Friday closing price of 165.308. There is a field in calculator which input quarterly dividend amount.
Dec 2014 ATM 165 puts value is 16.19 and Call value is 12.96.

http://www.cboe.com/framed/IVolframed.a ... 20Services


Image

If you look up option quote, 165 puts can be had at 16.39ish and 165 Calls at 12.57ish.

You could change to dividends to zero to figure out the option price, if you assume there won’t be any dividends. In fact, there is a product called SPX (SP500 cash index), which is an European type of options. There would be arbitrage opportunity, if SPY and SPX option prices differ significantly. SPX options are preferred for long term LEAPS, since there is no exercise risk as compared to American style of options.

Markettimer answered above why Long term LEAPS are not popular.
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