Lifecycle Investing Leverage Strategy Using LEAPS - How To?

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Park
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Lifecycle Investing Leverage Strategy Using LEAPS - How To?

Postby Park » Sun Jan 08, 2012 9:19 pm

In the book "Lifecycle Investing", leverage is recommended for retirement savings, if the time horizon is long enough. This post is about how one can implement this strategy using LEAPS (long term options).

My first disclaimer is I'm a novice when it comes to options. My second disclaimer is I'm NOT making a blanket endorsement of leverage. But for some investors, it is a reasonable option to consider. Those who consider it should think about it long and carefully.

The authors recommend buying LEAPS call options on SPY, an S&P500 ETF. The reason for SPY is its comparatively high liquidity, versus other options. This limits the diversification potential of this strategy.

Call options consist of elements of leverage and downside protection. The downside protection increases the implied interest rate. To make leverage work, one wants the implied interest rate as low as possible. Therefore, one wants minimal downside protection.

To keep the implied interest rate low, one wants the extrinsic volatility or time value of the call option to be as close to zero as possible.

One also wants the call option return to correlate as highly as possible with the return of SPY. In other words, one wants delta to be as close to 1.0 as possible.

To achieve these ends, the authors advocate 2 year deep in the money call options on SPY.

http://www.investopedia.com/articles/op ... z1iSnfqEBc

http://seekingalpha.com/article/28161-i ... n-steroids

The above 2 links provide a way to implement this strategy. It is suggested to roll over LEAPS call options: "a two-year LEAP call could be held for a single year and then sold and replaced by another two-year option."

The following is my variant, which comes from my experience as a buy and hold investor and with bond ladders.

Divide the money for this strategy into three equal portions. Buy LEAPS on SPY. One LEAPS expires in 1 year, the second in 2 years and the third in 3 years. Sell each LEAPS just prior to expiration. After each LEAPS is sold, buy a LEAPS that expires in 3 years. When one wants to end the leverage strategy, stop buying LEAPS each year.

My variant decreases the costs associated with bid ask spreads and commissions. It also diversifies LEAPS risk, by dividing LEAPS into three different years. However, it might increase the time value of the options purchased.

In both approaches, one sells the LEAPS call options. SPY is an equity settled option. When the option is exercised, one has the right to buy SPY shares at the exercise price. If one has the cash to buy the SPY shares, then exercising the option and selling the SPY shares might be less costly than selling the LEAPS call option. Also, if one has enough money, one could buy an option on S&P500 futures, $SPX.X. Such an option costs ten times as much as an option on SPY, but an $SPX.X option is cash settled, which means one doesn't have to pay the bid ask spread. This might also decrease cost.

Comments on how to implement this strategy using LEAPS are appreciated.

airahcaz
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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby airahcaz » Tue Jan 10, 2012 9:51 am

Park wrote:
Divide the money for this strategy into three equal portions. Buy LEAPS on SPY. One LEAPS expires in 1 year, the second in 2 years and the third in 3 years. Sell each LEAPS just prior to expiration. After each LEAPS is sold, buy a LEAPS that expires in 3 years. When one wants to end the leverage strategy, stop buying LEAPS each year.



I actually kind of like this, especially reducing bid ask spread and time value, etc, but what happens when one or all of the LEAPS lose significant value with a market downturn? have you run anything historically on the strategy?

Also, as far as I remember, there are no 3 year LEAPS, unless you mean 2.5 years?
1) Invest you must 2) Time is your friend 3) Impulse is your enemy 4) Basic arithmetic works 5) Stick to simplicity 6) Stay the course. (Plagiarized, but worth stealing)

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby market timer » Tue Jan 10, 2012 11:16 am

Since you are using deep-in-the-money LEAPS, the time premium will be very low as the option approaches maturity. It will likely be the case with such options that it is preferable to exercise early, or sell back to the market, before expiration. One quick check is to compare the value of the corresponding put with the dividend payment. If the put is worth 10 cents and an upcoming dividend payment is 50 cents, then one should sell back or exercise the call before the ex-dividend date.

There is another complication with exercising options in retirement accounts -- something I've never done. If you want to exercise the call option and buy the shares, what will your broker do if your account doesn't have enough cash? In a taxable account, you could simply add additional funds or take a temporary margin loan, but these aren't possible in retirement accounts.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby cjking » Tue Jan 10, 2012 11:31 am

How much more expensive (annual percentage overhead) will it be to run this leveraged strategy, compared to merely being 100% equities? (Just wondering.)

Probably the cheapest way to leverage is to put as little equity as possible into your home, invest 100% equties, then redirect savings to paying down your mortgage once your equity target is met. (Edit: suppose I might be overlooking that not everyone lives somewhere where a home costs as much as a fully-funded retirement portfolio.)

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Snowjob » Tue Jan 10, 2012 8:03 pm

I prefer to use margin in a taxable account when it comes to leverage. Having the ability to just add funds whenever I need to to pad my margin:equity ratio is essential. Also while I do use individual stocks I do keep my investments simple. When I see people come up with a plan to use options or other more complex strategies the famous Clausewitz quote seems to come to mind "the greatest enemy of a good plan is the dream of a perfect plan". I think your plan and the lifecycle investing approach fall into this category for me. Your trying to capture all the elements of diversification, tax efficiency and interest rate risk management. While this may work out well on paper today, I'm skeptical of the model's success over the long run as markets tend to be quite unpredictable. At very least, you may run into some of the issues that Market Timer described above.

That said, I like that your thinking outside the box. I know ideas like this get shot down fairly quickly on the website, but it makes for some interesting and though provoking disucssion -- especially for those of us who have read more index / efficient frontier / 3 factor articles than you can shake a stick at. :wink:

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby hollowcave2 » Tue Jan 10, 2012 8:09 pm

You have to think about risk management as well.

I'm aware of the 90/10 plan using LEAPS. This plan places 10% of your total portfolio into LEAPS on the S$P500, and the remaining 90% in Treasuries with a maturity matching the LEAP expiration. Even if you did nothing after entering the position, the most you are risking is less than 10% of your total portfolio. Then the plan is repeated after expiration. The basic bet is that you're not going to string together a bunch of losses because the market basically goes up in the long run. And if you buy deep ITM Leaps, risk is also managed in a flat market because you have little time value.

It's not a bad idea. I don't use it though. I'm not sure how I'd react to it. I guess it's not my style.

airahcaz
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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby airahcaz » Tue Jan 10, 2012 8:37 pm

hollowcave2 wrote:You have to think about risk management as well.

I'm aware of the 90/10 plan using LEAPS. This plan places 10% of your total portfolio into LEAPS on the S$P500, and the remaining 90% in Treasuries with a maturity matching the LEAP expiration. Even if you did nothing after entering the position, the most you are risking is less than 10% of your total portfolio. Then the plan is repeated after expiration. The basic bet is that you're not going to string together a bunch of losses because the market basically goes up in the long run. And if you buy deep ITM Leaps, risk is also managed in a flat market because you have little time value.

It's not a bad idea. I don't use it though. I'm not sure how I'd react to it. I guess it's not my style.


Any site or anyway to back test it?

What about 10% LEAPS and 90% SPY? ;)
1) Invest you must 2) Time is your friend 3) Impulse is your enemy 4) Basic arithmetic works 5) Stick to simplicity 6) Stay the course. (Plagiarized, but worth stealing)

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby grok87 » Tue Jan 10, 2012 9:04 pm

Park wrote:In the book "Lifecycle Investing", leverage is recommended for retirement savings, if the time horizon is long enough. This post is about how one can implement this strategy using LEAPS (long term options).

My first disclaimer is I'm a novice when it comes to options. My second disclaimer is I'm NOT making a blanket endorsement of leverage. But for some investors, it is a reasonable option to consider. Those who consider it should think about it long and carefully.

The authors recommend buying LEAPS call options on SPY, an S&P500 ETF. The reason for SPY is its comparatively high liquidity, versus other options. This limits the diversification potential of this strategy.

Call options consist of elements of leverage and downside protection. The downside protection increases the implied interest rate. To make leverage work, one wants the implied interest rate as low as possible. Therefore, one wants minimal downside protection.

To keep the implied interest rate low, one wants the extrinsic volatility or time value of the call option to be as close to zero as possible.

One also wants the call option return to correlate as highly as possible with the return of SPY. In other words, one wants delta to be as close to 1.0 as possible.

To achieve these ends, the authors advocate 2 year deep in the money call options on SPY.

http://www.investopedia.com/articles/op ... z1iSnfqEBc

http://seekingalpha.com/article/28161-i ... n-steroids

The above 2 links provide a way to implement this strategy. It is suggested to roll over LEAPS call options: "a two-year LEAP call could be held for a single year and then sold and replaced by another two-year option."

The following is my variant, which comes from my experience as a buy and hold investor and with bond ladders.

Divide the money for this strategy into three equal portions. Buy LEAPS on SPY. One LEAPS expires in 1 year, the second in 2 years and the third in 3 years. Sell each LEAPS just prior to expiration. After each LEAPS is sold, buy a LEAPS that expires in 3 years. When one wants to end the leverage strategy, stop buying LEAPS each year.

My variant decreases the costs associated with bid ask spreads and commissions. It also diversifies LEAPS risk, by dividing LEAPS into three different years. However, it might increase the time value of the options purchased.

In both approaches, one sells the LEAPS call options. SPY is an equity settled option. When the option is exercised, one has the right to buy SPY shares at the exercise price. If one has the cash to buy the SPY shares, then exercising the option and selling the SPY shares might be less costly than selling the LEAPS call option. Also, if one has enough money, one could buy an option on S&P500 futures, $SPX.X. Such an option costs ten times as much as an option on SPY, but an $SPX.X option is cash settled, which means one doesn't have to pay the bid ask spread. This might also decrease cost.

Comments on how to implement this strategy using LEAPS are appreciated.

You might be interested in this thread
viewtopic.php?t=71927

I think buying deep-in-the-money calls is not the greatest idea. The problem is you will be overpaying for the options in general. This is because a lot of people want to buy out of the money puts. So that pushes up the implied volatility at that those strikes. This affects the calls as well due to put-call parity.
There was an article on this on bloomberg today but I can't find it right now...
cheers,
"...people always live for ever when there is any annuity to be paid them"- Jane Austen

Park
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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Park » Fri Jan 20, 2012 11:57 pm

For this strategy to be successful, the LEAPS return must be greater than the implied interest rate

The authors of Lifecycle Investing did an analysis of the implied interest rates from 1996 to 2009 for deep in the money call options on the S&P500 that resulted in effective leverage of around 2 to 1. The average implied interest rate was 26 bp above the contemporaneous call money rate and 1.89% over the 1 year treasury note. There was variability in the implied interest rate, especially due to volatility. In their leverage models, they assumed the broker “call money” rate plus 30 bp.

http://islandia.law.yale.edu/ayers/Dive ... ssTime.pdf

A major problem with leverage is the rebalancing. When one rebalances between stocks and bonds, results tend to improve, as one tends to buy low and sell high. Leverage is akin to negative bonds, and things work in reverse. When one rebalances between negative bonds and stocks, results are worse, as one tends to buy high and sell low. Losses that are reversible in an unlevered account can become irreversible in a levered account.

The following is from the link below. From 1958 to 2009, the S&P500 was up 53% of days and down 47% of days; for months, 58% up and 42% down; for quarters, 63% up and 37% down; for years 72% up and 28% down; for 5 year rolling time periods, 76% up and 24% down; for 10 year rolling time periods, 88% up and 12% down. The above data ignore the impact of reinvested dividends.

http://moneyover55.about.com/od/howtoin ... arkets.htm

For options and futures, when they expire, one is forced to rebalance. The longer the time interval until one rebalances, the more likely that the LEAPS return will be greater than the implied interest rate. Futures last in the range of months. With LEAPS, an option can last up to 3 years. So it makes sense to buy a 3 year LEAP option each year to replace the one that is expiring. Such a LEAPS ladder strategy minimizes rebalancing and provides some diversification of risk by having a 3 year LEAPS ladder with a rung at each year.

If one uses margin and one gets a margin call, that is a form of rebalancing. Also, one is forced to rebalance at the worst possible time. However, if one uses modest amounts of leverage, the probability of a margin call is small, and one may never have to rebalance.

A second major problem is leverage is the asymmetry between losses and gains. If the market declines 50% and you’re unlevered (leverage ratio of 1.0), you need a 100% return to get back where you were. With a leverage ratio of 1.5, your decline is 75%, and you need a 300% return to get back to where you were. With a leverage ratio of 2.0, your decline is 100% and you’re “wiped out”.

What is the optimal leverage ratio? An analysis of this found the optimal leverage ratio was 1.7; the link to the paper is given below.

http://www2.stetson.edu/fsr/abstracts/v ... m1_p33.pdf

The same authors performed an analysis on the Canadian stock market, and found the optimal leverage ratio was 1.5. The link is given below. Obviously, this data is less relevant. However, I find the second paper easier to understand. In the second paper, they rebalance monthly to keep the leverage ratio constant. As mentioned above, if one rebalances over longer periods of time, results will tend to be better. With longer intervals between rebalancing, a higher leverage ratio might be optimal, although I personally wouldn't feel comfortable with a higher level of leverage.

http://www.investmentreview.com/files/2 ... olios1.pdf

This LEAPS strategy is only for retirement accounts, where one can’t use margin. It hasn’t been back tested, and if anyone uses it, I would use it modestly.

Both SPY and $SPX.X are options on the S&P500, SPY being an American option and $SPX.X being a European option. I notice that for both options, one can see negative time value (negative extrinsic value) with deep in the money options. What is the explanation for the negative time value?

Market Timer, you wrote: “Since you are using deep-in-the-money LEAPS, the time premium will be very low as the option approaches maturity. It will likely be the case with such options that it is preferable to exercise early, or sell back to the market, before expiration. One quick check is to compare the value of the corresponding put with the dividend payment. If the put is worth 10 cents and an upcoming dividend payment is 50 cents, then one should sell back or exercise the call before the ex-dividend date.”

I don’t completely understand this, which reflects my level of options knowledge. Could you dumb this down for me?

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby market timer » Sat Jan 21, 2012 9:19 am

Park wrote:Both SPY and $SPX.X are options on the S&P500, SPY being an American option and $SPX.X being a European option. I notice that for both options, one can see negative time value (negative extrinsic value) with deep in the money options. What is the explanation for the negative time value?

Market Timer, you wrote: “Since you are using deep-in-the-money LEAPS, the time premium will be very low as the option approaches maturity. It will likely be the case with such options that it is preferable to exercise early, or sell back to the market, before expiration. One quick check is to compare the value of the corresponding put with the dividend payment. If the put is worth 10 cents and an upcoming dividend payment is 50 cents, then one should sell back or exercise the call before the ex-dividend date.”

I don’t completely understand this, which reflects my level of options knowledge. Could you dumb this down for me?


These two questions are related. European options can only be exercised at the expiration date, while American options can be exercised anytime. A call option is like owning a stock (but without the dividends), owning a put at the same strike, and taking out a loan. Negative time value in European options arises when the value of the downside protection (the put option) plus the interest on the loan is less than the foregone dividends. A simple example may help to clarify. Consider stock XYZ trading at 100. You want to buy a 50-strike call expiring December 21, 2012. To keep things easy, suppose that the interest rate is 0% and the value of the 50-strike put is $0.05. Now, here is one complication: the stock pays a $1 dividend with an ex-div date of December 15, 2012.

If you work out the algebra on this, you'll see that the European option has a negative time premium (negative $.95), while the American option has a time premium of $.05. The difference is that the American option will be exercised on December 14, 2012, so its holder will receive the dividend.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Snowjob » Sat Jan 21, 2012 10:01 am

I have a question for the OP.

Is all of this a theoretical exerciese or have do you actually plan on implementing this? The reason I ask is in your last post you refrenced historical returns / volitility and an optimal leverage rate. I have been leveraged since mid 2008. Had I been levered 1.7x I most certainly would have been hit with many margin calls. As you mentioned the rebalancing affect of a levered portfolio via margin calls is devistating and I still stand by my opinion that any leverage should be in a taxable account that gives you the flexibility to draw on other cash sources to keep your portfolio intact.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Snowjob » Sat Jan 21, 2012 10:10 am

Why dont you just get a portfolio margin account at IB. that allows for higher leverage since your using broad investments instead of individual stocks. You will still get the rock bottom margin rates and have the ability to add cash as needed.

Park
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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Park » Sat Jan 21, 2012 10:09 pm

If someone said that they would only use leverage in taxable accounts, they would have no argument from me. If someone said that they wouldn’t use leverage at all, ditto. However, it should be noted that the tax deferral of some retirement accounts and of unrealized capital gains are both forms of leverage. Similarly, anyone with a mortgage and stock/bond investments is levered.

Leverage using margin has several advantages
-to get leverage, you pay interest; to get leverage with options, you have to pay the additional cost of a hedge
-margin will most likely result in decreased costs of commissions and bid ask spreads
-margin can result in tax arbitrage; interest costs may be fully deductible against income (depends on local tax laws), and capital gains tend to be taxed at lower rates than income and can be deferred; it is theoretically possible for leverage to result in a loss on a pretax basis, but come out ahead on a posttax basis
-you can pay your interest every year; this means you pay simple interest, but you get compound return
-you may never have to rebalance, whereas you must rebalance with options
-diversification is much easier

Leverage using options has some advantages
-if you want high leverage ratios, options are probably better suited to that than margin loans
-no risk of a margin call
-you know the implied rate of interest, whereas with margin loans, it’s a floating rate
-and the most important reason for me, it’s the only way I know of getting leverage in a retirement account

Is this a theoretical exercise? I am interested in leverage in my retirement accounts. There isn’t much information available about how best to do that. So this thread was designed to get input on a possible strategy. I may implement this, I may not.

In the 2008 bear market, the S&P500 went down 56.6%. If one assumes a 25% maintenance margin requirement, an S&P500 investor with a leverage ratio of 1.48 or higher got a margin call. If one had rebalanced, it would have been less of an issue; however, the rebalancing would have come at a price. However, I’m not recommending a leverage ratio of 1.7. I use leverage, and my ratio is considerably less than that.

About a taxable account allowing one to draw on other cash sources to prevent a margin call, it does allow one to do that. But if one is maintaining a cash reserve in anticipation of a possible margin call, that may be defeating the purpose of using margin. It is unlikely that the return from the cash reserve will be greater than the interest on the margin loan.

Upthread I give data from Ayres and Nalebuff on implied interest rates on S&P500 LEAPS. The interest rate data is from 1 year options. It is certainly possible that the implied interest rates on longer options is greater.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Snowjob » Sun Jan 22, 2012 10:13 pm

Perhaps a portfolio margin account has a more lax standard on ration. Normal accounts at IB are 50% enforced automatically at the end of the day, with a very generous 25% enforcable during regular trading hours. Also there are other means to cover your margin call risk than having a boatload of cash in a savings account -- primarily you could draw on other lines of credit. With regards to your option scheme, I wish you success. I personally have no need to lever both my taxable and my tax advantaged accounts, so I will stick with just the taxable one. I have a defined set or risks primarilly a funding risk, and many ways to cover it.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Liquid » Sun Jan 22, 2012 10:41 pm

market timer wrote: LEAPS


Market timer you should post a link to your forum master class on this subject. Also how is the portfolio doing these days?

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby market timer » Sun Jan 22, 2012 11:51 pm

Liquid wrote:
market timer wrote: LEAPS


Market timer you should post a link to your forum master class on this subject. Also how is the portfolio doing these days?


Park is familiar with my old strategy, and I think that the signal-to-noise is low in that thread. It's more about the psychology of self-destruction than how to leverage a portfolio.

After three years of debt repayment, and I mean really massive bills arriving every month, I've built up such an aversion to debt and leverage that I'll never take these kinds of risks again. My portfolio managed a 13% gain last year, and by living modestly and saving, it's grown to $200K. Perhaps when the time is right, I'll trade more seriously again. I've learned not to make any excuses and to trust no one.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Liquid » Sun Jan 22, 2012 11:59 pm

market timer wrote:After three years of debt repayment, and I mean really massive bills arriving every month, I've built up such an aversion to debt and leverage that I'll never take these kinds of risks again. My portfolio managed a 13% gain last year, and by living modestly and saving, it's grown to $200K. Perhaps when the time is right, I'll trade more seriously again. I've learned not to make any excuses and to trust no one.


Thats great, I am glad to hear that you are back in the black. :beer

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Park » Mon Jan 23, 2012 7:46 pm

Snowjob wrote:Normal accounts at IB are 50% enforced automatically at the end of the day, with a very generous 25% enforcable during regular trading hours.


http://www.interactivebrokers.com/en/ge ... Margin.php

Snowjob, about the 50% enforced automatically at the end of the day, I believe that you're referring to the special memorandum account. My interpretation of the SMA, with the emphasis on the words my interpretation, is that as long as you don't sell after buying stocks on margin, the SMA is a nonissue.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Snowjob » Mon Jan 23, 2012 9:01 pm

I've recieved the 3:50pm email alert to my smart phone saying I was in violation of my margin requirements when I forgot to hit submit on a sell order while swaping positions

Re your link, It explains further down that page "At the end of the trading day, IB applies the Regulation T initial margin requirement"

Its my understanding that if you use a portfolio margin account the requirements are different.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Park » Tue Jan 24, 2012 9:16 am

http://www.interactivebrokers.com/en/p. ... =overview1

If you go to the examples section, it looks like IB determines the end of day margin requirement by using the SMA. The SMA can be determined by 2 different methods, and the method that is more favorable to the investor is used. One method is the initial maintenance margin. However, the other method is more complicated. My interpretation is that if you're a buy and hold investor, the SMA is a nonissue based on the second method.

However, I would definitely recommend checking with IB.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Park » Fri Feb 03, 2012 7:40 pm

Just because an investment is levered doesn’t mean that it is necessarily more risky than an investment that is unlevered. How risky the underlying investment that is being levered plays an important role in overall risk. A relevant link is given below. That’s why currency traders commonly use 100 times leverage, whereas stock traders don’t come close to that.

http://aima-canada.org/doc_bin/AIMA_Can ... verage.pdf

Below is a link to a paper that examines the effect of leverage on the ability to retire early.

http://gosset.wharton.upenn.edu/research/retirement.pdf

As mentioned above, a major problem with leverage is that losses that would be reversible without leverage can become irreversible with leverage. With margin, losses become irreversible with a margin call. With options and futures, losses can become irreversible when the derivative nears expiration. The problem is the underlying volatility of the investment being levered. If the price of the investment always went up, however slowly, the risk of irreversible loss would decrease considerably. It’s the periodic downturns that hurt leverage.

One way to decrease the risk of periodic downturns is diversification. It is somewhat ironic that Bogleheads, with their index portfolios, may be among the best candidates for leverage. It is another reason why margin, with its increased ability to allow diversification, may be a better way to achieve leverage than derivatives.

Another way to decrease the risk of irreversible loss is to limit the amount of leverage. As mentioned above, there’s an asymmetry between losses and gains even in unlevered portfolios. With increasing leverage, that asymmetry becomes greater. Assume a 50% market downturn. With leverage ratios of 1.0, 1.25, 1.50, 1.75, you need the market to increase by 100%, 167%, 300% and 700% to get back to where you once were.

I provide links to two papers about leverage ratios above; those papers found that the optimal leverage ratios for the US stock market and the Canadian stock market were 1.7 and 1.5 respectively. In both papers, the tax arbitrage that may be available with margin lending is not part of the analysis. Also, the result would most likely be better if leverage was applied to a diversified portfolio, and not just to the portfolio of stocks of one nation. Finally, at least the paper about the Canadian stock market, which I more readily understood as it was designed more for the lay reader, rebalanced monthly. Such frequent rebalancing will decrease the risk of a margin call, but will also decrease return, a point that I will come to later.

IMO, a well diversified stock portfolio, to which a modest amount of leverage using margin has been applied, has a small risk of a margin call. The problem with options is that it’s difficult to get a small amount of leverage. At present, SPY is around 131. The lowest strike price, resulting in the least amount of leverage, on a 3 year option on SPY is 60. This results in a leverage ratio of around 1.87. If the market is down 54% by the time the option expires, you’ve lost everything.

I’ve mentioned two problems with options. However, options are not without their advantages. If one uses margin, one has to continue to pay interest. If one runs into financial difficulties, such as job loss, then making interest payments could be a problem. With options, it’s not an issue.

I’ve mentioned diversification and limiting the leverage ratio as two ways to decrease the risk of irreversible losses with leverage. Another way is time. The longer one holds a stock index investment, the less likely that there will be a loss and the less severe the loss will be. For S&P500 from 1973 to mid 2009, the worst rolling 3 year period was around minus 18%; for 1 year holding period, it was around minus 42%.

http://moneyover55.about.com/od/stockma ... eturns.htm

That’s why I like 3 years LEAPS over shorter term LEAPS. That’s also why I don’t like futures, where the contracts are for months.
In a retirement account, the best way that I can think of obtaining leverage is 3 year options on SPY, going as deep in the money as possible. One buys an option one year, repeats that the next year, and once again in the following year. This results in a 3 year ladder, which should help to diversify risk.

What to do if one has a lump sum? Upthread, I mention buying a 1 year LEAPs, a 2 year LEAPS and a 3 year LEAPS. I’ve thought about it, and think the following is a better way. Buy a 3 year LEAPS. In one year, if the return will be positive, sell 1/3 of the LEAPS and buy a 3 year LEAPS. In two years, if the return will be positive, sell another part of the original 3 year LEAPS and buy another 3 year LEAPS. With this revised strategy, one may end up concentrating risk at the end of 3 years. However, the original strategy leaves one susceptible to market declines at 1 and 2 years.

I took a look at 2 year LEAPS. Two year LEAPS are available with a strike price as low as 20. This results in a leverage ratio as low as 1.2. As mentioned previously, the lowest leverage ratio with a 3 year LEAPS is 1.87. So from a decreased leverage point of view, I like 2 year LEAPS. However, with a 2 year LEAPS, the probability of a market downturn at the end of 2 years is greater than with a 3 year LEAPS. Also, if there is a market downturn, the probability of it being less severe is greater with a 3 year LEAPS than a 2 year LEAPS. There is the increased cost of commissions and bid ask spreads with a 2 year LEAPS ladder. Finally, 2 year LEAP ladders have 2 rungs, whereas 3 year LEAP ladders have 3 rungs giving more diversification.

I took a look at $SPX.X. That’s an option on S&P500 futures, and they also go out to 3 years. They have the advantage that one can get a leverage ratio as low as 1.2 on a 3 year option. Bid ask spread is definitely higher than with options on SPY. However, SPY is an American option, which is settled in stocks. $SPX.X is a European option, which is settled in cash. That means with SPY, one may end up buying and selling the same option, so one may pay the bid ask spread twice. With $SPX.X, one might end up not selling the option, and be exposed to the bid ask spread only once. Based on my cursory examination of bid ask spreads, the bid ask spread on $SPX.X may be double or less than that of options on SPY. However, a contract on $SPX.X required ten times as much money as that of a option on SPY. That will result in less commissions, but commissions at least at my broker, are not a major issue. But the amount of money required for $SPX.X means that it isn’t practical for me.

What about rebalancing? That’s an advantage of options. In a market downturn, one might have to rebalance a portfolio levered with a margin loan to prevent a margin call. Rebalancing tends to result in selling low. Losses become irreversible. Also, there is the cost of commissions and bid ask spreads.

With options, there is no margin call. If there is a market downturn, one can just wait it out. The longer the LEAPS, the longer one can wait it out. However, when it gets near the expiration of the LEAPS, waiting is no longer an option.

As the market declines, a deep in the money call option will start to behave more like an at the money call option. If things are really bad, it will become an out of the money call option. Time value (aka extrinsic value) becomes important.

The following is from page 384-5 of "Options as a Strategic Investment". If I buy a LEAPS option on SPY with a strike price of $60 and SPY having a present value of around $130, consider the following scenarios. Assume the market has gone down 54%, so my option is at the money. However, it will still have time value. Based on the chart on page 384, keep the option until it has 6 months until expration. If one holds it past this point, the time value will decrease markedly. Assume the market has gone down 65%, so my option is 20% out of the money. Once again, it still has time value. In this case, sell the option with 12 months remaining, as its time value will markedly decrease after this point.

So my rebalancing rules are as follows. Don't consider rebalancing until one year is left in the LEAPS. At the one year mark, sell the LEAPS if it is out of the money. If it is at the money or better, don't sell. At the 6 month mark, if the LEAPS is less than 20% in the money, sell it. If it is sufficiently in the money (20% or greater), don't sell it and keep it until just prior to expiration.

I’ve bought call options on SPY that expire in December 2014; the strike price is $60.00 and the cost was $73.10.

My purpose with this post is to help those who might be considering a leveraged strategy for their retirement savings. I’ve been helped by others on this board, and I’m trying to give something back in return. The topic is probably not appropriate for the Bogleheads wiki, so I’ve used this format instead. I welcome criticisms. If one decides to use a leveraged strategy, please think about it long and carefully. Certainly do not base your decisions on the information in this thread alone. It is very reasonable to decide that leverage is not for oneself. I’d like to thank Market Timer for helpful comments.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Liquid » Fri Feb 03, 2012 7:59 pm

Speculation that S&P 500 will be up over a 3yr period, or you "lose everything," seems like a very very bad idea given market history. Let us know how this works out and good luck to you.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby grok87 » Sat Feb 04, 2012 9:45 am

Park wrote:
I’ve bought call options on SPY that expire in December 2014; the strike price is $60.00 and the cost was $73.10.


I've bought call options on SPY that expire in December 2014: the strike price is $150.00 and the cost was $9.24.

You are overpaying for your options by buying deep in the money. Too many people want to buy puts there...
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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby airahcaz » Sat Feb 04, 2012 9:57 am

Liquid wrote:Speculation that S&P 500 will be up over a 3yr period, or you "lose everything," seems like a very very bad idea given market history. Let us know how this works out and good luck to you.


Agree, needs to be tested, but the overall strategy of buying furthest and deepest leaps and 'hoping' to roll within a year of expiration has risk that the roll happens in a significant down year. Not sure how that is accommodated - hmm.
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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby market timer » Sat Feb 04, 2012 10:20 am

grok87 wrote:
Park wrote:
I’ve bought call options on SPY that expire in December 2014; the strike price is $60.00 and the cost was $73.10.


I've bought call options on SPY that expire in December 2014: the strike price is $150.00 and the cost was $9.24.

You are overpaying for your options by buying deep in the money. Too many people want to buy puts there...
cheers,


Park's goal is to mimic the performance of the S&P at the lowest interest rate possible and without mark-to-market risk. Out-of-the-money calls will differ considerably from the index. Note that the breakeven point for the 150 calls is about 20% above today's level, not counting dividends. These are lotto tickets, not foundations for a portfolio that tries to capture the ERP.

My problem with Park's trade is that he went too far in-the-money. The issue was alluded to in my first post in this thread. For low enough strike options, the value of downside protection and borrowing costs are worth less than the foregone dividends. Park will miss four quarters of 2012 divs, 4 quarters of 2013 divs, and 3 quarters of 2014 divs, about $7.15 based on the most recent payout (likely higher). He's also borrowing $60 for 2.8 years, so that's worth around $1.20. The corresponding put is worth about $2.60. Basically, even before we consider him being charged a time premium, if he holds to expiration, he's out $7.15 in dividends for $3.80 in downside protection and borowing costs. If this were a European option, it would have a negative time premium. Instead, as an American option, it's only worth holding until a day before the March 2012 ex-div date. He basically bought a 2-month option, not a 3-year option. Notice that it is priced the same as the March 2012 60 strike option, just with a wider bid/offer. My suggestion is to find an option with a long maturity where it is not efficiently exercised within 2 months.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby airahcaz » Sat Feb 04, 2012 10:41 am

market timer wrote:
grok87 wrote:
Park wrote:
I’ve bought call options on SPY that expire in December 2014; the strike price is $60.00 and the cost was $73.10.


I've bought call options on SPY that expire in December 2014: the strike price is $150.00 and the cost was $9.24.

You are overpaying for your options by buying deep in the money. Too many people want to buy puts there...
cheers,


Park's goal is to mimic the performance of the S&P at the lowest interest rate possible and without mark-to-market risk. Out-of-the-money calls will differ considerably from the index. Note that the breakeven point for the 150 calls is about 20% above today's level, not counting dividends. These are lotto tickets, not foundations for a portfolio that tries to capture the ERP.

My problem with Park's trade is that he went too far in-the-money. The issue was alluded to in my first post in this thread. For low enough strike options, the value of downside protection and borrowing costs are worth less than the foregone dividends. Park will miss four quarters of 2012 divs, 4 quarters of 2013 divs, and 3 quarters of 2014 divs, about $7.15 based on the most recent payout (likely higher). He's also borrowing $60 for 2.8 years, so that's worth around $1.20. The corresponding put is worth about $2.60. Basically, even before we consider him being charged a time premium, if he holds to expiration, he's out $7.15 in dividends for $3.80 in downside protection and borowing costs. If this were a European option, it would have a negative time premium. Instead, as an American option, it's only worth holding until a day before the March 2012 ex-div date. He basically bought a 2-month option, not a 3-year option. Notice that it is priced the same as the March 2012 60 strike option, just with a wider bid/offer. My suggestion is to find an option with a long maturity where it is not efficiently exercised within 2 months.


suggestions on the time and strike then?
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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby market timer » Sat Feb 04, 2012 10:49 am

airahcaz wrote:suggestions on the time and strike then?


Someone who wants a 3-year option instead of one efficiently exercised after 2 months can look at the market prices for a given strike by expiration date, then identify where the market is bidding more for the longer dated options. This lets the market do the math for you. I think the reason Park selected the 60s was because he wanted roughly 2:1 leverage, but there is no reason why he can't pick a higher strike and keep some cash uninvested or in bonds.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Park » Sat Feb 04, 2012 2:23 pm

The last dividend from SPY was 0.770313. So missing 11 dividends results in a loss of $8.47, and probably more, as the dividend will most likely increase.

The corresponding put last sold at $2.64.

Although I bought an American option, it has a time value of minus 1.77. Correct me if I'm wrong, but won't the time value go to zero, if I hold it until near expration? The March 2012 60 strike option has a time value of minus 0.19.

So that leaves $4.06.

That works out to a simple interest rate of 2.42%. On a compounded basis, it will be slightly less. That's a fixed rate for the next 2.8 years.

http://islandia.law.yale.edu/ayers/Dive ... ssTime.pdf

I can't reproduce Table 1 in the above link, but that's where this information is coming from. Ayers and Nalebuff looked at implied interest rates for 1 year S&P calls from 1996 to 2009. Calls were grouped by the following leverage ratios: 1.5-2.5, 2.5-3.5, 3.5-4.5, 4.5-5.5 and 5.5-6.5. The mean spread over the 1 year treasury note was 1.89%, 2.79%, 4.19%, 5.20% and 6.42% for the respective groups.

Right now, the 1 year treasury note yield 0.13%. So the spread of my option over the 1 year treasury note is 2.29%. I paid 0.30% more than the mean spread. But I bought a 2.8 year option. It wouldn't surprise me if the implied interest rate on a 2.8 year option is greater than that of options expiring in 11-12 months; the latter options are those on which the above data comes from. FWIW, the 3 year treasury note yields 0.32, and the spread of my option over the 3 year treasury note is 2.1%.

If I had chosen an option that was not as deep in the money, would my implied interest rate not have been higher?

As I am an options novice, I could be wrong in this analysis, and I welcome criticism.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby market timer » Sat Feb 04, 2012 2:30 pm

Park wrote:The last dividend from SPY was 0.770313. So missing 11 dividends results in a loss of $8.47, and probably more, as the dividend will most likely increase.


Q4 has a higher dividend payout than other quarters. You'd get a more accurate result by looking at the past four quarters.

Although I bought an American option, it has a time value of minus 1.77.


Based on what? Are you using your price paid vs. current market price for SPY? Use current options prices vs. current prices for the underlying. American options can never have negative time value. If an option did, you could buy it, exercise it immediately, sell the shares, and earn a risk-free profit.

Correct me if I'm wrong, but won't the time value go to zero, if I hold it until near expration?


True.

If I had chosen an option that was not as deep in the money, would my implied interest rate not have been higher?


This is not necessarily true if we allow the investor to exercise options inefficiently, even ignoring transaction costs.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Park » Sat Feb 04, 2012 2:37 pm

I got the negative time values from the option chain data provided by TD Ameritrade.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby market timer » Sat Feb 04, 2012 2:43 pm

Park wrote:I got the negative time values from the option chain data provided by TD Ameritrade.


I'm not sure how they are calculating time value. The bid/offer spread is quite wide on this option. Marking the price at the bid would give a negative time value, meaning it would be more efficient to exercise the option than sell it at the bid. The offer has positive time value.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Park » Sat Feb 04, 2012 3:31 pm

http://www.investopedia.com/exam-guide/ ... z1lRffuQH8

"American options are rarely exercised early. This is because all options have a non-negative time value and are usually worth more unexercised. Owners who wish to realize the full value of their options will mostly prefer to sell them rather than exercise them early and sacrifice some of the time value."

So Market timer, investopedia not surprisingly agrees with you.

When I look at the bid ask spread of SPY call options with an exercise price of $60.00, I notice that it is greatest for the Dec 20/14 option at $73.98/$74.77. As the time to maturity decreases, the spread gradually decreases until the minimum spread of $74.23/$74.50 is reached with the June 16/12 option. So if one holds the option long enough, the bid ask spread decreases from around 1.06% to around 0.36%. The bid ask spread of SPY call options with an exercise price of $60 doesn't seem to correlate with open interest; instead, it seems to correlate with the time to maturity.

It would not surprise me if this is a manifestation of efficient markets in action. The implied interest rate on a 3 year option should be greater than that of a 2 month option.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby airahcaz » Sat Feb 04, 2012 3:43 pm

Park wrote:http://www.investopedia.com/exam-guide/cfa-level-1/derivatives/european-versus-american-options-moneyness.asp#axzz1lRffuQH8

"American options are rarely exercised early. This is because all options have a non-negative time value and are usually worth more unexercised. Owners who wish to realize the full value of their options will mostly prefer to sell them rather than exercise them early and sacrifice some of the time value."

So Market timer, investopedia not surprisingly agrees with you.

When I look at the bid ask spread of SPY call options with an exercise price of $60.00, I notice that it is greatest for the Dec 20/14 option at $73.98/$74.77. As the time to maturity decreases, the spread gradually decreases until the minimum spread of $74.23/$74.50 is reached with the June 16/12 option. So if one holds the option long enough, the bid ask spread decreases from around 1.06% to around 0.36%. The bid ask spread of SPY call options with an exercise price of $60 doesn't seem to correlate with open interest; instead, it seems to correlate with the time to maturity.

It would not surprise me if this is a manifestation of efficient markets in action. The implied interest rate on a 3 year option should be greater than that of a 2 month option.


...but you will not hold the option "long enough", cause your strategy rolls the option, right?

so you'll always be hit with a significant B/A spread when buying and selling as part of the rolling...
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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Park » Sat Feb 04, 2012 3:50 pm

The plan is to keep the option until just prior to its expiration. So when I buy, I will pay a significant B/A spread, but when I sell, it should be less. However, as mentioned upthread, I might sell the option up to 1 year prior to expiration, if things aren't going well. Even then though, the bid ask spread will have decreased, compared to that at the time of purchase.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby market timer » Sat Feb 04, 2012 4:04 pm

The fundamental issue here is not the bid/ask spread, but rather the optimal exercise date. The optimal exercise date, barring a market meltdown, for the option you purchased is the day before SPY goes ex-div in March 2012. When SPY goes ex-div, the fair value on that option will decline by nearly the full amount of the dividend. This will happen on each ex-div date for the next 3 years, again barring a market meltdown. Simply put, the strike price is too low and the divs on SPY too high to make this a viable long term American option.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby nisiprius » Sat Feb 04, 2012 4:08 pm

Park wrote:However, if one uses modest amounts of leverage, the probability of a margin call is small, and one may never have to rebalance.
One must consider not just probability, but consequences.
After three years of debt repayment, and I mean really massive bills arriving every month, I've built up such an aversion to debt and leverage that I'll never take these kinds of risks again.
Those are the consequences of a margin call.

I would add this. As I noted in another thread, in Ayres and Nalebuff's book, Lifecycle Investing, one of the vehicles they mention as a sensible way of implementing their strategy is the ProFunds UltraBull mutual fund, a 2X daily leveraged S&P fund. They mention it in their paper as well, where they derive an implied interest rate and conclude that it compares favorably with the brokerage margin lending rates. In the paper, they don't actually say how to use the fund, but it is not clear why they would bother to extract an implied interest rate if they didn't think it could be used.

The UltraBull mutual fund, according to the fund company, "seeks daily investment results, before fees and expenses, that correspond to twice (200%) the daily performance of the S&P 500." They also say that
Investors should monitor holdings consistent with their strategies, as frequently as daily.
But in a lifecycle investing strategy, I imagine one would buy and hold this fund, and the professors do not indicate how else you should use it. If you had done that, this is what would have happened:
Image
The "200%" fund managed to "grow" $10,000 into $6,395 while the boring old Vanguard Index 500 grew it to $16,605.

Subject to correction by those who understand these things, I think they were idiots to think this fund could be used to implement their strategy, and considerably worse than idiots to say so in a how-to book that investors might act on. It makes you wonder what soft spots there might be in the rest of their advice.
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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Park » Sat Feb 04, 2012 4:41 pm

I see where you're coming from Market Timer.

Look at the prices on the 60 call on SPY. With a December 20/14 expiration, the price is 73.98/74.77. As mentioned above, the bid ask spread decreases, but the midprice really doesn't change. With a Feb 18/12 expiration, the price is 74.23/74.50.

Look at the prices on the 600 call on $SPX.X. With a December 20/14 expiration, the price is 679.60/703.50. As the time to expiration decreases, the price consistently increases. The highest price is the Feb 18/12 expiration at 739.20/743.30.

The price of $SPX.X call options is taking into account lost dividends, but the price of SPY call options isn't. Although this is tangential, the bid ask spread decreases as the time to expiration decreases on $SPX.X.

From what I can see, if you want to use long term deep in the money options, European options are the way to go. I still like the idea of deep in the money options, as I want my implied interest rate to be as low as possible. To do that, one wants the put part of the option to have a value as close to zero as possible. That means deep in the money options, which still give me more leverage than I want. But the fact that American options don't take into account dividends makes long term deep in the money American options a bad idea. The only problem is the high cost of $SPX.X.

Nisiprius, I wouldn't recommend anyone holding a leveraged ETF more than one day. Daily rebalancing hurts leverage; you want as long as possible between rebalancing to make leverage work. That's why I advocate 3 year LEAPS. If one has a leverage ratio of 1.25 and has a maintenance margin requirement of 25%, a market decline of 73.3% would be required for a margin call. If one is using index funds and has a significant international exposure, the probability of that is small. Also, if you have a line of credit, more than a 73.3% decline would be required.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby market timer » Sat Feb 04, 2012 4:53 pm

If your broker allows you to trade spreads, you can synthesize the European option you want using American options. You could buy a 130 call, sell a 130 put, and buy a 60 put for a given expiration. This combination allows you to synthesize a European 60-strike call, with some slight technical differences surrounding the final dividend payment. If all buys occur at the offer, and all sells occur at the bid, this combination lowers interest costs by over $3 relative to the 60-strike call, mainly because you receive compensation for foregone dividends by not having a binding non-negative time premium constraint. This is also an indication of how much you lose by not exercising efficiently.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby airahcaz » Sat Feb 04, 2012 5:00 pm

It's certainly a lot of data, including historical bid / ask spreads, but any way to back test, to when LEAPS first came to market?
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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Park » Sat Feb 04, 2012 5:01 pm

MT, thanks for the sage advice. Unfortunately, I don't think I can sell calls in a retirement account. You should write a book about this :) .

I would be very interested in back tested results, but I'm not aware of any. And as an average retail investor, I don't have the ability to back test.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby market timer » Sat Feb 04, 2012 5:11 pm

Park wrote:MT, thanks for the sage advice. Unfortunately, I don't think I can sell calls in a retirement account. You should write a book about this :) .

I would be very interested in back tested results, but I'm not aware of any. And as an average retail investor, I don't have the ability to back test.


Actually, an even easier way is to buy futures (allowed in a retirement account) and buy puts (also allowed). This gives you your 60 call at a lower price.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Park » Sat Feb 04, 2012 5:19 pm

Yes, that would work. I'll be selling the options that I just bought. I'll have to think about the alternatives.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby airahcaz » Sat Feb 04, 2012 5:24 pm

Park wrote:MT, thanks for the sage advice. Unfortunately, I don't think I can sell calls in a retirement account. You should write a book about this :) .

I would be very interested in back tested results, but I'm not aware of any. And as an average retail investor, I don't have the ability to back test.


Me too. I guess we don't have the same tools available to the professionals or it takes a lot of spreadsheet work toget Ye backtesting right.

I'm fully on board for log term Leaps, but there was always the issue of them only going 3 years out. When I asked in a separate thread about longer options, even say a decade plus, that was also something only a derivatives shop could cook up, a la for Buffet.
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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Park » Sat Feb 04, 2012 6:20 pm

I like futures, because you're paying for leverage only; there's no downside protection that you're paying for. But futures last no more than 5 months. So one is rebalancing every 5 months, and that could cause problems. With LEAPS, rebalancing every 3 years is more than I really would like to.

To make this strategy work using LEAPS call options, one wants the cost of the put option, that is part of the call option cost, to be as small as possible.

Let's examine $SPX.X. The December 2014 600 call option costs around $700. The December 2014 put option costs around $28. So that's an extra $28 added to the cost of one's $600 loan. Spread over 2.8 years, that increases the effective interest rate by around 1.7%. The leverage ratio is 1.85. The December 3014 450 call option costs around $825. The December 2014 put option costs around $10. So that's an extra $10 added to the cost of one's $450 loan. Spread over 2.8 years, that increases the effective interest rate by 0.8%. The leverage ratio is 1.58. To get the effective interest rate down, one has to go very deep in the money. Also, the bid ask spread on the 450 call is around 2.8%. Spread over 2.8 years, that increases the effective interest rate by 0.5%, if one assumes the option is held until expiration. The effect of the bid ask spread on the 600 call is to increase the effective interest rate by 0.6%. And there's still the not so small problem of contract size.
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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby market timer » Sat Feb 04, 2012 6:28 pm

Park wrote:I like futures, because you're paying for leverage only; there's no downside protection that you're paying for. But futures last no more than 5 months. So one is rebalancing every 5 months, and that could cause problems. With LEAPS, rebalancing every 3 years is more than I really would like to.


In practice, one would need to roll futures quarterly, incurring a round-trip spread of 0.25 with each roll for e-mini S&P futures. Over 3 years, this is 3 points, equivalent to 30 cents on the SPY contracts. That is about one-third the spread on the Dec 2014 60 call.

If your concern is about mark-to-market risk, holding a long-dated put against short term futures makes the position nearly identical to a European call (i.e., having none of the early exercise problems highlighted above for the American call). The key differences between the positions are: (1) futures are effectively borrowing at a floating rate with 3-month resets, rather than 3-year fixed rate with call options; (2) futures only include expectations for this quarter's dividends, while options prices include longer term forecasts.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Park » Sat Feb 04, 2012 6:56 pm

From 1958 to 2009, the S&P500 was up 53% of days and down 47% of days; for months, 58% up and 42% down; for quarters, 63% up and 37% down; for years 72% up and 28% down; for 5 year rolling time periods, 76% up and 24% down; for 10 year rolling time periods, 88% up and 12% down. The above data ignore the impact of reinvested dividends. IOW, the stock market is highly volatile, but volatility decreases with longer time periods.

Volatility and the assymetry between gains and losses hurt leverage. That's why leveraged ETFs don't usually work, if held more than one day. Admittedly, 3 months is better than 1 day. But every 3 months, one runs the risk of losses becoming irreversible using futures.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby market timer » Sat Feb 04, 2012 7:05 pm

Park wrote:Volatility and the assymetry between gains and losses hurt leverage. That's why leveraged ETFs don't usually work, if held more than one day. Admittedly, 3 months is better than 1 day. But every 3 months, one runs the risk of losses becoming irreversible using futures.


But you aren't varying the number of contracts every three months. You would roll the same number of contracts and own LEAPS puts to protect against mark-to-market volatility. The position is essentially the same as a LEAPS call option (minor caveats noted above).

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Park » Sat Feb 04, 2012 7:08 pm

Could you dumb this down for me with an example?

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby market timer » Sat Feb 04, 2012 7:12 pm

Park wrote:Could you dumb this down for me with an example?


Suppose your position was 5 SPY 60-strike calls. Now imagine what would happen if you replaced that with an e-mini future (rolled quarterly) plus 5 SPY 60-strike puts. Whatever strategy you had (when to sell, whether to buy more) can be replicated with this combination. The quarterly rolling is irrelevant to your risk exposure. Think of the bid/ask spread as a small tax that must be paid.

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Re: Lifecycle Investing Leverage Strategy Using LEAPS - How

Postby Park » Sat Feb 04, 2012 7:38 pm

Please correct me if I'm wrong in the following.

Assume the S&P500 starts at 1300. Assume it goes down to 975 after one quarter. Assume it goes down to 650 after 2 quarters. Assume it goes back up to 975 after the third quarter. Assume it goes back up to 1300 after the fourth quarter.

Assume I bought a 3 year money option on the $SPX.X at the start, when the S&P500 was 1300. The leverage ratio is 2. After one year, my option has not significantly changed in price.

Assume I bought an S&P500 futures contract with a leverage ratio of 2. After 3 months, my contract is at 50% of its original value. After 6 months, it's at 25%. After 9 months, its' at 37.5%. After one year, it's at 50% of the original value.


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