Lifecycle Investing - Leveraging when young

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
no simpler
Posts: 108
Joined: Sat Jul 13, 2019 4:54 pm

Re: Lifecycle Investing - Leveraging when young

Post by no simpler » Wed Dec 18, 2019 6:03 pm

305pelusa wrote:
Wed Dec 18, 2019 5:29 pm
no simpler wrote:
Wed Dec 18, 2019 4:27 pm
Generally when people think they've found a "cheaper" way to replicate a position, they're not accounting for something.
I can't comment on TLT but I actually tend to find options to be significantly cheaper than futures. I might be doing something wrong but I can't figure out why. Maybe you can help.

Just now I looked at a synthetic option position and it has a borrowing rate of ~1.8%. This makes sense, that's basically what the Tbills/LIBOR/etc are at. However, I'm looking at the March 2020 future on the S&P 500 E-Mini. I see right now:

Contract cost = 3199.25
The S&P 500 closed just an hour ago at = 3191.14
The dividend yield is at ~1.9%

So you can buy the S&P at 3191.14. Or get the contract, pay an extra 8.11 in cost basis ("contango") and miss a dividend of ~15 dollars. So you're overpaying by 23.11 to have exposure to the index for about a quarter. That would annualize to ~92.44 dollars on an exposure of 3191.14, which is ~2.8%. Am I missing something?
you don't miss a dividend, whether with futures or options. It's accounted for in the price, e.g. you will make up for it in price appreciation of the contract. Otherwise there would be an incredible arb opp: you could hold the underlying while shorting the future to collect the dividend risk free (in case of futures) or hold the underlying and create a synthetic short (in case of options).

https://en.wikipedia.org/wiki/Put%E2%80%93call_parity. The higher the dividend, the lower the futures price (and hence greater appreciation if held till delivery, all else equal) and the lower the cost of establishing a synthetic long in case of options.

langlands
Posts: 100
Joined: Wed Apr 03, 2019 10:05 pm

Re: Lifecycle Investing - Leveraging when young

Post by langlands » Wed Dec 18, 2019 6:41 pm

305pelusa wrote:
Wed Dec 18, 2019 5:54 pm
langlands wrote:
Wed Dec 18, 2019 5:41 pm
To put it another way, why do almost all leveraged ETFs choose to use futures instead of options to replicate their positions? The money seems too free.
There are some disadvantages to options. They're not perfect synthetic positions like futures are.

That said, if I had to guess, it's because the sheer volume of options you'd need to buy/sell for a mutual fund might be quite large. And daily reconstitution potentially very obnoxious and pricey. At least futures come in much larger sizes. Even then, they're probably a pain for large institutions. My understand is that LETFs like UPRO use neither; they use actual derivative swaps that they negotiate with other financial institutions and that are specific to them. These swaps, in UPRO's case at least, have higher costs than the risk-free rate as well. Once again, probably because with the sheer volume of daily trades, it's easier to have contracts with specific institutions to gain your exposure instead of going into the market place every day.
Yes, you seem to be right. I just found the thread discussing simulating leveraged etfs that go into excruciating detail in the computation of the spreads. I have no idea why S&P 500 and Russell 2000 spreads would differ by so much.

User avatar
Topic Author
305pelusa
Posts: 1321
Joined: Fri Nov 16, 2018 10:20 pm

Re: Lifecycle Investing - Leveraging when young

Post by 305pelusa » Wed Dec 18, 2019 6:52 pm

no simpler wrote:
Wed Dec 18, 2019 6:03 pm
305pelusa wrote:
Wed Dec 18, 2019 5:29 pm
no simpler wrote:
Wed Dec 18, 2019 4:27 pm
Generally when people think they've found a "cheaper" way to replicate a position, they're not accounting for something.
I can't comment on TLT but I actually tend to find options to be significantly cheaper than futures. I might be doing something wrong but I can't figure out why. Maybe you can help.

Just now I looked at a synthetic option position and it has a borrowing rate of ~1.8%. This makes sense, that's basically what the Tbills/LIBOR/etc are at. However, I'm looking at the March 2020 future on the S&P 500 E-Mini. I see right now:

Contract cost = 3199.25
The S&P 500 closed just an hour ago at = 3191.14
The dividend yield is at ~1.9%

So you can buy the S&P at 3191.14. Or get the contract, pay an extra 8.11 in cost basis ("contango") and miss a dividend of ~15 dollars. So you're overpaying by 23.11 to have exposure to the index for about a quarter. That would annualize to ~92.44 dollars on an exposure of 3191.14, which is ~2.8%. Am I missing something?
you don't miss a dividend, whether with futures or options. It's accounted for in the price, e.g. you will make up for it in price appreciation of the contract. Otherwise there would be an incredible arb opp: you could take delivery of underlying (in case of futures) or exercise to buy underlying (in case of options) right before dividend is paid out. In practice, this is impossible because the price of underlying goes down by roughly the dividend amount in anticipation, with usually no net change in synthetic positions.

https://en.wikipedia.org/wiki/Put%E2%80%93call_parity
You don't get a dividend with derivatives for sure. That is built in the price in the sense that it's part of the implied borrowing cost. That's why you have to account for it in order to extract the implied rate. Also, that's why futures some times trade in backwardation. Yes, the contract is cheaper but you must factor in the lack of a dividend.

Also, did you look at the link you posted? Look at the last equation from section Statement, and solve for B(t,T). All else equal, as D(T) increases (the dividend payout), B(t,T) decreases. B(t,T) is the present value of a zero coupon that matures to $1 at the time of expiration. That's what defines the interest rate. The lower that present value, the higher the interest rate.

The CME's equation is the same thing, for futures:
https://www.cmegroup.com/education/file ... ancing.pdf

Note that given a FV and Spot price, as dividend increases, financing increases. Using their equation:

Contract price = Spot price * (1 + R*(days/365)) - Dividend
3199.25 = 3191.14 * (1 + R*88/365) - 14.44
R = 2.93%

Exactly what I got before :confused

langlands
Posts: 100
Joined: Wed Apr 03, 2019 10:05 pm

Re: Lifecycle Investing - Leveraging when young

Post by langlands » Wed Dec 18, 2019 7:00 pm

305pelusa wrote:
Wed Dec 18, 2019 6:52 pm
no simpler wrote:
Wed Dec 18, 2019 6:03 pm
305pelusa wrote:
Wed Dec 18, 2019 5:29 pm
no simpler wrote:
Wed Dec 18, 2019 4:27 pm
Generally when people think they've found a "cheaper" way to replicate a position, they're not accounting for something.
I can't comment on TLT but I actually tend to find options to be significantly cheaper than futures. I might be doing something wrong but I can't figure out why. Maybe you can help.

Just now I looked at a synthetic option position and it has a borrowing rate of ~1.8%. This makes sense, that's basically what the Tbills/LIBOR/etc are at. However, I'm looking at the March 2020 future on the S&P 500 E-Mini. I see right now:

Contract cost = 3199.25
The S&P 500 closed just an hour ago at = 3191.14
The dividend yield is at ~1.9%

So you can buy the S&P at 3191.14. Or get the contract, pay an extra 8.11 in cost basis ("contango") and miss a dividend of ~15 dollars. So you're overpaying by 23.11 to have exposure to the index for about a quarter. That would annualize to ~92.44 dollars on an exposure of 3191.14, which is ~2.8%. Am I missing something?
you don't miss a dividend, whether with futures or options. It's accounted for in the price, e.g. you will make up for it in price appreciation of the contract. Otherwise there would be an incredible arb opp: you could take delivery of underlying (in case of futures) or exercise to buy underlying (in case of options) right before dividend is paid out. In practice, this is impossible because the price of underlying goes down by roughly the dividend amount in anticipation, with usually no net change in synthetic positions.

https://en.wikipedia.org/wiki/Put%E2%80%93call_parity
You don't get a dividend with derivatives for sure. That is built in the price in the sense that it's part of the implied borrowing cost. That's why you have to account for it in order to extract the implied rate. Also, that's why futures some times trade in backwardation. Yes, the contract is cheaper but you must factor in the lack of a dividend.

Also, did you look at the link you posted? Look at the last equation from section Statement, and solve for B(t,T). All else equal, as D(T) increases (the dividend payout), B(t,T) decreases. B(t,T) is the present value of a zero coupon that matures to $1 at the time of expiration. That's what defines the interest rate. The lower that present value, the higher the interest rate.

The CME's equation is the same thing, for futures:
https://www.cmegroup.com/education/file ... ancing.pdf

Note that given a FV and Spot price, as dividend increases, financing increases. Using their equation:

Contract price = Spot price * (1 + R*(days/365)) - Dividend
3199.25 = 3191.14 * (1 + R*88/365) - 14.44
R = 2.93%

Exactly what I got before :confused
I think I more or less agree now that the spread on SPY futures is pretty high. But it's not 100 bps, more like 50 bps. Note that the Dec 2019 futures price, which expires in 2 days is trading at 3195, which seems like a more accurate input instead of 3191. Then you'll get R around 2.4 or 2.5.

User avatar
Topic Author
305pelusa
Posts: 1321
Joined: Fri Nov 16, 2018 10:20 pm

Re: Lifecycle Investing - Leveraging when young

Post by 305pelusa » Wed Dec 18, 2019 7:13 pm

langlands wrote:
Wed Dec 18, 2019 7:00 pm
305pelusa wrote:
Wed Dec 18, 2019 6:52 pm
no simpler wrote:
Wed Dec 18, 2019 6:03 pm
305pelusa wrote:
Wed Dec 18, 2019 5:29 pm
no simpler wrote:
Wed Dec 18, 2019 4:27 pm
Generally when people think they've found a "cheaper" way to replicate a position, they're not accounting for something.
I can't comment on TLT but I actually tend to find options to be significantly cheaper than futures. I might be doing something wrong but I can't figure out why. Maybe you can help.

Just now I looked at a synthetic option position and it has a borrowing rate of ~1.8%. This makes sense, that's basically what the Tbills/LIBOR/etc are at. However, I'm looking at the March 2020 future on the S&P 500 E-Mini. I see right now:

Contract cost = 3199.25
The S&P 500 closed just an hour ago at = 3191.14
The dividend yield is at ~1.9%

So you can buy the S&P at 3191.14. Or get the contract, pay an extra 8.11 in cost basis ("contango") and miss a dividend of ~15 dollars. So you're overpaying by 23.11 to have exposure to the index for about a quarter. That would annualize to ~92.44 dollars on an exposure of 3191.14, which is ~2.8%. Am I missing something?
you don't miss a dividend, whether with futures or options. It's accounted for in the price, e.g. you will make up for it in price appreciation of the contract. Otherwise there would be an incredible arb opp: you could take delivery of underlying (in case of futures) or exercise to buy underlying (in case of options) right before dividend is paid out. In practice, this is impossible because the price of underlying goes down by roughly the dividend amount in anticipation, with usually no net change in synthetic positions.

https://en.wikipedia.org/wiki/Put%E2%80%93call_parity
You don't get a dividend with derivatives for sure. That is built in the price in the sense that it's part of the implied borrowing cost. That's why you have to account for it in order to extract the implied rate. Also, that's why futures some times trade in backwardation. Yes, the contract is cheaper but you must factor in the lack of a dividend.

Also, did you look at the link you posted? Look at the last equation from section Statement, and solve for B(t,T). All else equal, as D(T) increases (the dividend payout), B(t,T) decreases. B(t,T) is the present value of a zero coupon that matures to $1 at the time of expiration. That's what defines the interest rate. The lower that present value, the higher the interest rate.

The CME's equation is the same thing, for futures:
https://www.cmegroup.com/education/file ... ancing.pdf

Note that given a FV and Spot price, as dividend increases, financing increases. Using their equation:

Contract price = Spot price * (1 + R*(days/365)) - Dividend
3199.25 = 3191.14 * (1 + R*88/365) - 14.44
R = 2.93%

Exactly what I got before :confused
I think I more or less agree now that the spread of SPY futures is pretty high. But it's not 100 bps, more like 50 bps. Note that the Dec 2019 futures price, which expires in 2 days is trading at 3195, which seems like a more accurate input instead of 3191. Then you'll get R around 2.4 or 2.5.
Well that's even weirder. Not sure how a contract could trade 50 bps higher with 2 days to expiration. That's like an easy 250 buck profit if you buy 50 shares of S&P 500 and sell a contract. You don't even need capital; borrow 150k on margin to buy the stocks. At 3% margin, you'd pay around 24 bucks to carry the position.

There must be some second-order effects here we just don't know much about. Personally, I stay away from futures because calculations like these seem to imply costs that are too high. Either they're true and they're a bad deal. Or they're false and I don't know why. Either way, I stay away.

User avatar
abuss368
Posts: 17195
Joined: Mon Aug 03, 2009 2:33 pm
Location: Where the water is warm, the drinks are cold, and I don't know the names of the players!
Contact:

Re: Lifecycle Investing - Leveraging when young

Post by abuss368 » Wed Dec 18, 2019 7:18 pm

An investor has to be crazy to go into debt (margin) to invest. Many investors have experienced financial ruin doing just that. I hope the book is objective enough to discuss that.

Jack Bogle has said not one should go into debt to invest.

I always thought this was very sound advice.
John C. Bogle - Two Fund Portfolio: Total Stock & Total Bond. "Simplicity is the master key to financial success."

guyinlaw
Posts: 220
Joined: Wed Jul 03, 2019 9:54 am

Re: Lifecycle Investing - Leveraging when young

Post by guyinlaw » Wed Dec 18, 2019 9:41 pm

abuss368 wrote:
Wed Dec 18, 2019 7:18 pm
An investor has to be crazy to go into debt (margin) to invest. Many investors have experienced financial ruin doing just that. I hope the book is objective enough to discuss that.

Jack Bogle has said not one should go into debt to invest.

I always thought this was very sound advice.
Did you buy your house paying cash or did you get a mortgage? How much down payment did you make? How much leverage did that come to?

Would your generic comments about margin and debt be applicable to buying a house as well?

Please read the paper and the book. If you find any mistakes in it, please share.
305pelusa wrote:
Wed Dec 18, 2019 1:08 pm

I would probably start with the paper:
https://papers.ssrn.com/sol3/papers.cfm ... id=1149340

I was sold just on the theory and logic of it. It's nice to see the backtest overwhelmingly favor it too.

The thread I started to document the process is (I hope) a good resource:
viewtopic.php?f=10&t=274390

Finally, they came out with a book. It's on Amazon:
https://www.amazon.com/Lifecycle-Invest ... 449&sr=8-3

If you sign up for Audible, you can use the credit to get the audio book for free. I liked it so much, I bought the book so they'd get some royalties. It has completely changed my investing mindset.

no simpler
Posts: 108
Joined: Sat Jul 13, 2019 4:54 pm

Re: Lifecycle Investing - Leveraging when young

Post by no simpler » Wed Dec 18, 2019 10:54 pm

305pelusa wrote:
Wed Dec 18, 2019 6:52 pm
no simpler wrote:
Wed Dec 18, 2019 6:03 pm
305pelusa wrote:
Wed Dec 18, 2019 5:29 pm
no simpler wrote:
Wed Dec 18, 2019 4:27 pm
Generally when people think they've found a "cheaper" way to replicate a position, they're not accounting for something.
I can't comment on TLT but I actually tend to find options to be significantly cheaper than futures. I might be doing something wrong but I can't figure out why. Maybe you can help.

Just now I looked at a synthetic option position and it has a borrowing rate of ~1.8%. This makes sense, that's basically what the Tbills/LIBOR/etc are at. However, I'm looking at the March 2020 future on the S&P 500 E-Mini. I see right now:

Contract cost = 3199.25
The S&P 500 closed just an hour ago at = 3191.14
The dividend yield is at ~1.9%

So you can buy the S&P at 3191.14. Or get the contract, pay an extra 8.11 in cost basis ("contango") and miss a dividend of ~15 dollars. So you're overpaying by 23.11 to have exposure to the index for about a quarter. That would annualize to ~92.44 dollars on an exposure of 3191.14, which is ~2.8%. Am I missing something?
you don't miss a dividend, whether with futures or options. It's accounted for in the price, e.g. you will make up for it in price appreciation of the contract. Otherwise there would be an incredible arb opp: you could take delivery of underlying (in case of futures) or exercise to buy underlying (in case of options) right before dividend is paid out. In practice, this is impossible because the price of underlying goes down by roughly the dividend amount in anticipation, with usually no net change in synthetic positions.

https://en.wikipedia.org/wiki/Put%E2%80%93call_parity
You don't get a dividend with derivatives for sure. That is built in the price in the sense that it's part of the implied borrowing cost. That's why you have to account for it in order to extract the implied rate. Also, that's why futures some times trade in backwardation. Yes, the contract is cheaper but you must factor in the lack of a dividend.

Also, did you look at the link you posted? Look at the last equation from section Statement, and solve for B(t,T). All else equal, as D(T) increases (the dividend payout), B(t,T) decreases. B(t,T) is the present value of a zero coupon that matures to $1 at the time of expiration. That's what defines the interest rate. The lower that present value, the higher the interest rate.

The CME's equation is the same thing, for futures:
https://www.cmegroup.com/education/file ... ancing.pdf

Note that given a FV and Spot price, as dividend increases, financing increases. Using their equation:

Contract price = Spot price * (1 + R*(days/365)) - Dividend
3199.25 = 3191.14 * (1 + R*88/365) - 14.44
R = 2.93%

Exactly what I got before :confused
it's possible futures are simply in contango from high demand - we're in a raging bull market. I use options, not futures, so definitely won't argue against options for creating synthetic longs. Even so, this is a bit odd. Tired right now, but will try to figure out what's going on tomorrow. That is a pretty high cost of financing, above some broker margin rates, so seems off to me.

Starfish
Posts: 1554
Joined: Wed Aug 15, 2018 6:33 pm

Re: Lifecycle Investing - Leveraging when young

Post by Starfish » Wed Dec 18, 2019 11:02 pm

abuss368 wrote:
Wed Dec 18, 2019 7:18 pm
An investor has to be crazy to go into debt (margin) to invest. Many investors have experienced financial ruin doing just that. I hope the book is objective enough to discuss that.

Jack Bogle has said not one should go into debt to invest.

I always thought this was very sound advice.

Interesting.... most people do exactly that: have mortgage, student loans, car loans, credit card loans etc and investments, at the same time.

User avatar
Topic Author
305pelusa
Posts: 1321
Joined: Fri Nov 16, 2018 10:20 pm

Re: Lifecycle Investing - Leveraging when young

Post by 305pelusa » Wed Dec 18, 2019 11:09 pm

no simpler wrote:
Wed Dec 18, 2019 10:54 pm
305pelusa wrote:
Wed Dec 18, 2019 6:52 pm
no simpler wrote:
Wed Dec 18, 2019 6:03 pm
305pelusa wrote:
Wed Dec 18, 2019 5:29 pm
no simpler wrote:
Wed Dec 18, 2019 4:27 pm
Generally when people think they've found a "cheaper" way to replicate a position, they're not accounting for something.
I can't comment on TLT but I actually tend to find options to be significantly cheaper than futures. I might be doing something wrong but I can't figure out why. Maybe you can help.

Just now I looked at a synthetic option position and it has a borrowing rate of ~1.8%. This makes sense, that's basically what the Tbills/LIBOR/etc are at. However, I'm looking at the March 2020 future on the S&P 500 E-Mini. I see right now:

Contract cost = 3199.25
The S&P 500 closed just an hour ago at = 3191.14
The dividend yield is at ~1.9%

So you can buy the S&P at 3191.14. Or get the contract, pay an extra 8.11 in cost basis ("contango") and miss a dividend of ~15 dollars. So you're overpaying by 23.11 to have exposure to the index for about a quarter. That would annualize to ~92.44 dollars on an exposure of 3191.14, which is ~2.8%. Am I missing something?
you don't miss a dividend, whether with futures or options. It's accounted for in the price, e.g. you will make up for it in price appreciation of the contract. Otherwise there would be an incredible arb opp: you could take delivery of underlying (in case of futures) or exercise to buy underlying (in case of options) right before dividend is paid out. In practice, this is impossible because the price of underlying goes down by roughly the dividend amount in anticipation, with usually no net change in synthetic positions.

https://en.wikipedia.org/wiki/Put%E2%80%93call_parity
You don't get a dividend with derivatives for sure. That is built in the price in the sense that it's part of the implied borrowing cost. That's why you have to account for it in order to extract the implied rate. Also, that's why futures some times trade in backwardation. Yes, the contract is cheaper but you must factor in the lack of a dividend.

Also, did you look at the link you posted? Look at the last equation from section Statement, and solve for B(t,T). All else equal, as D(T) increases (the dividend payout), B(t,T) decreases. B(t,T) is the present value of a zero coupon that matures to $1 at the time of expiration. That's what defines the interest rate. The lower that present value, the higher the interest rate.

The CME's equation is the same thing, for futures:
https://www.cmegroup.com/education/file ... ancing.pdf

Note that given a FV and Spot price, as dividend increases, financing increases. Using their equation:

Contract price = Spot price * (1 + R*(days/365)) - Dividend
3199.25 = 3191.14 * (1 + R*88/365) - 14.44
R = 2.93%

Exactly what I got before :confused
it's possible futures are simply in contango from high demand - we're in a raging bull market. I use options, not futures, so definitely won't argue against options for creating synthetic longs. Even so, this is a bit odd. Tired right now, but will try to figure out what's going on tomorrow. That is a pretty high cost of financing, above some broker margin rates, so seems off to me.
Yeah, let me know if you can figure it out. I'll check again when they're both trading.




Have you done any synthetic longs on LT treasuries? You mentioned TLT before. It's a little weird to go long a security that doesn't actually appreciate in price. I assume the option prices are such that the synthetic long can be set up at some form of discount to somehow make up for it. The math shouldn't be that bad I don't think.

Uncorrelated
Posts: 278
Joined: Sun Oct 13, 2019 3:16 pm

Re: Lifecycle Investing - Leveraging when young

Post by Uncorrelated » Thu Dec 19, 2019 2:39 am

langlands wrote:
Wed Dec 18, 2019 5:41 pm
I hope someone can weigh in on the math here as this as this is something I'd really like to know. But it just seems extremely implausible to me that the implied financing on the futures could be higher than options since the SPY futures market is one of the most liquid in the world, certainly much more liquid than options. To put it another way, why do almost all leveraged ETFs choose to use futures instead of options to replicate their positions? The money seems too free.
I have been doing a ton of research on this topic and the simple answer is that we don't know. See viewtopic.php?f=10&t=272640&start=200#p4884654 and viewtopic.php?f=10&t=272640&start=250#p4895487 for some details.

According to the efficient market hypothesis one would expect the futures implied repo rate to be the same as the options implied borrow rate. If that doesn't seem to be the case the most likely explanation is that we're calculating it wrong.

UntoTheBreach
Posts: 4
Joined: Sun May 19, 2019 1:35 pm

Re: Lifecycle Investing - Leveraging when young

Post by UntoTheBreach » Thu Dec 19, 2019 6:28 am

Image
Image
Implied interest rates according to CME roll analyzer for the Dec to Mar roll.
So confirms 50 bps spread for ES vs libor and Russel being cheaper
I was surprised how much these spreads fluctuate. (+25bps for ES in 2 weeks)
Also very surprising to see cost of Mar to Jun Roll is negative (not in screenshot), so it's seems Mar contract is being a bit of an outlier

User avatar
Topic Author
305pelusa
Posts: 1321
Joined: Fri Nov 16, 2018 10:20 pm

Re: Lifecycle Investing - Leveraging when young

Post by 305pelusa » Thu Dec 19, 2019 7:47 am

UntoTheBreach wrote:
Thu Dec 19, 2019 6:28 am
Image
Image
Implied interest rates according to CME roll analyzer for the Dec to Mar roll.
So confirms 50 bps spread for ES vs libor and Russel being cheaper
I was surprised how much these spreads fluctuate. (+25bps for ES in 2 weeks)
Also very surprising to see cost of Mar to Jun Roll is negative (not in screenshot), so it's seems Mar contract is being a bit of an outlier
Thank you! This confirms what I’ve noticed before

Can you link that tool please?

no simpler
Posts: 108
Joined: Sat Jul 13, 2019 4:54 pm

Re: Lifecycle Investing - Leveraging when young

Post by no simpler » Thu Dec 19, 2019 9:30 am

305pelusa wrote:
Wed Dec 18, 2019 11:09 pm
no simpler wrote:
Wed Dec 18, 2019 10:54 pm
305pelusa wrote:
Wed Dec 18, 2019 6:52 pm
no simpler wrote:
Wed Dec 18, 2019 6:03 pm
305pelusa wrote:
Wed Dec 18, 2019 5:29 pm


I can't comment on TLT but I actually tend to find options to be significantly cheaper than futures. I might be doing something wrong but I can't figure out why. Maybe you can help.

Just now I looked at a synthetic option position and it has a borrowing rate of ~1.8%. This makes sense, that's basically what the Tbills/LIBOR/etc are at. However, I'm looking at the March 2020 future on the S&P 500 E-Mini. I see right now:

Contract cost = 3199.25
The S&P 500 closed just an hour ago at = 3191.14
The dividend yield is at ~1.9%

So you can buy the S&P at 3191.14. Or get the contract, pay an extra 8.11 in cost basis ("contango") and miss a dividend of ~15 dollars. So you're overpaying by 23.11 to have exposure to the index for about a quarter. That would annualize to ~92.44 dollars on an exposure of 3191.14, which is ~2.8%. Am I missing something?
you don't miss a dividend, whether with futures or options. It's accounted for in the price, e.g. you will make up for it in price appreciation of the contract. Otherwise there would be an incredible arb opp: you could take delivery of underlying (in case of futures) or exercise to buy underlying (in case of options) right before dividend is paid out. In practice, this is impossible because the price of underlying goes down by roughly the dividend amount in anticipation, with usually no net change in synthetic positions.

https://en.wikipedia.org/wiki/Put%E2%80%93call_parity
You don't get a dividend with derivatives for sure. That is built in the price in the sense that it's part of the implied borrowing cost. That's why you have to account for it in order to extract the implied rate. Also, that's why futures some times trade in backwardation. Yes, the contract is cheaper but you must factor in the lack of a dividend.

Also, did you look at the link you posted? Look at the last equation from section Statement, and solve for B(t,T). All else equal, as D(T) increases (the dividend payout), B(t,T) decreases. B(t,T) is the present value of a zero coupon that matures to $1 at the time of expiration. That's what defines the interest rate. The lower that present value, the higher the interest rate.

The CME's equation is the same thing, for futures:
https://www.cmegroup.com/education/file ... ancing.pdf

Note that given a FV and Spot price, as dividend increases, financing increases. Using their equation:

Contract price = Spot price * (1 + R*(days/365)) - Dividend
3199.25 = 3191.14 * (1 + R*88/365) - 14.44
R = 2.93%

Exactly what I got before :confused
it's possible futures are simply in contango from high demand - we're in a raging bull market. I use options, not futures, so definitely won't argue against options for creating synthetic longs. Even so, this is a bit odd. Tired right now, but will try to figure out what's going on tomorrow. That is a pretty high cost of financing, above some broker margin rates, so seems off to me.
Yeah, let me know if you can figure it out. I'll check again when they're both trading.




Have you done any synthetic longs on LT treasuries? You mentioned TLT before. It's a little weird to go long a security that doesn't actually appreciate in price. I assume the option prices are such that the synthetic long can be set up at some form of discount to somehow make up for it. The math shouldn't be that bad I don't think.
yep, you can establish a synthetic long in TLT with a net credit, eg you will get more cash from the short put then it costs for the long call. So this is a very tangible example of not losing interest payments. You don't literally get interest payments of course, but you collect the present value of future interest payments for the length of a contract when establishing the position (less cost of financing, etc).
Last edited by no simpler on Thu Dec 19, 2019 9:53 am, edited 1 time in total.

no simpler
Posts: 108
Joined: Sat Jul 13, 2019 4:54 pm

Re: Lifecycle Investing - Leveraging when young

Post by no simpler » Thu Dec 19, 2019 9:40 am

The quotes I'm seeing now for S&P futures are flat or in backwardation, except for March 2020. Not sure why that contract is in contango.

User avatar
Topic Author
305pelusa
Posts: 1321
Joined: Fri Nov 16, 2018 10:20 pm

Re: Lifecycle Investing - Leveraging when young

Post by 305pelusa » Thu Dec 19, 2019 9:48 am

no simpler wrote:
Thu Dec 19, 2019 9:40 am
The quotes I'm seeing now for S&P futures are flat or in backwardation...
Yes they look reasonable now (1.8% implied). So one might initially conclude the spot price we were using was unfair since it was after trading. However, langland also did it using the Dec one (which, at this point in the year, should be essentially the spot price) and got ~2.4%.

I’d say there are general irregularities from time to time with these quotes that I can’t explain. Be it chance or lack of trying, I’ve never found it with options. Not sure why.

User avatar
Topic Author
305pelusa
Posts: 1321
Joined: Fri Nov 16, 2018 10:20 pm

Re: Lifecycle Investing - Leveraging when young

Post by 305pelusa » Thu Dec 19, 2019 9:49 am

no simpler wrote:
Thu Dec 19, 2019 9:40 am
The quotes I'm seeing now for S&P futures are flat or in backwardation, except for March 2020. Not sure why that contract is in contango.
Whoah a second ago the March one was at 3197. Just checked again once you edited your post and saw it at 3200. :confused

no simpler
Posts: 108
Joined: Sat Jul 13, 2019 4:54 pm

Re: Lifecycle Investing - Leveraging when young

Post by no simpler » Thu Dec 19, 2019 9:54 am

305pelusa wrote:
Thu Dec 19, 2019 9:49 am
no simpler wrote:
Thu Dec 19, 2019 9:40 am
The quotes I'm seeing now for S&P futures are flat or in backwardation, except for March 2020. Not sure why that contract is in contango.
Whoah a second ago the March one was at 3197. Just checked again once you edited your post and saw it at 3200. :confused
Might be a combination of expectations around near term changes in dividends and interest rates?

UntoTheBreach
Posts: 4
Joined: Sun May 19, 2019 1:35 pm

Re: Lifecycle Investing - Leveraging when young

Post by UntoTheBreach » Thu Dec 19, 2019 11:29 am

305pelusa wrote:
Thu Dec 19, 2019 7:47 am
Thank you! This confirms what I’ve noticed before

Can you link that tool please?
https://www.cmegroup.com/trading/equity ... /main.html
need to make a free account to use it

EfficientInvestor
Posts: 268
Joined: Thu Nov 01, 2018 7:02 pm
Location: Alabama

Re: Lifecycle Investing - Leveraging when young

Post by EfficientInvestor » Thu Dec 19, 2019 11:44 am

S&P has an index that tracks the total return associated with rolling an S&P 500 futures contract every quarter. It is based on having 100% cash collateral and is rolled 5 days prior to the last trade date of each contract. You can read the methodology and download the last 10 years of data at the link below. I pulled this data a few months ago and uploaded it to Portfolio Visualizer. Portfolio 1 below is the actual data. In comparing it to VFINX, you can see that it has underperformed by 31 bps over the time period. However, if you were to replicate this by assuming 10% of your funds would be used as margin or as idle cash earning 0% and the other 90% of your funds were sitting in an ultrashort bond fund (MINT), you would have actually performed better than VFINX. Over the time period, MINT had a SD of 0.46% and a max drawdown of -0.55%, so you aren't taking on too much risk relative to cash by using it.

https://kr.spindices.com/indices/strate ... s-index-tr

Image

ebot
Posts: 7
Joined: Thu Nov 07, 2019 5:48 pm

Re: Lifecycle Investing - Leveraging when young

Post by ebot » Thu Jan 02, 2020 12:15 pm

Just curious why you chose to buy at the 295 strike price (when the SPY was also near 2950) instead of closer to ~50% strike as the book suggested (~145)? I'm curious because I implemented the strategy closer to 50% strike price but looking at my performance compared to yours has resulted in roughly 3x less performance (just on the call option. I didn't sell any naked puts).

djeayzonne
Posts: 49
Joined: Wed Dec 06, 2017 2:14 pm

Re: Lifecycle Investing - Leveraging when young

Post by djeayzonne » Wed Jan 08, 2020 3:09 pm

I have read this entire thread, then the book, then other things while starting to plan my strategy, and then just read this entire thread again.

I have some follow up questions now that I feel I understand things a bit better.

1. I really don't understand the reason to sell the naked put. I understand the parity and that the implied interest is a bit less than just the call, but so what? I feel like OP just wanted to do this without having to spend any money and justified it (not an attack, just really trying to understand the value of it).

2. Somewhat related to 1.
If you truly believe in this philosophy and wanted your total stock exposure constant at the target amount as soon as possible, why wouldn't you just continue to buy a new call as soon as you had enough to buy the next one? Who cares what the leverage ratio is because your losses are limited? Who cares about the slightly higher implied interest because you would reach 100% of your target exposure as quickly as can possibly happen while keeping a sane amount of risk. What's more, as soon as you reach it, you can immediately (as soon as you have enough funds to replace one call, anyway) then start the process of deleveraging.

I feel like I'm missing something (like, Is there too much risk of the calls becoming worthless even if the market trends up depending on actual movement patterns?, etc.) because, otherwise, why wouldn't you do it this way?

User avatar
Topic Author
305pelusa
Posts: 1321
Joined: Fri Nov 16, 2018 10:20 pm

Re: Lifecycle Investing - Leveraging when young

Post by 305pelusa » Wed Jan 08, 2020 3:30 pm

djeayzonne wrote:
Wed Jan 08, 2020 3:09 pm
1. I really don't understand the reason to sell the naked put. I understand the parity and that the implied interest is a bit less than just the call, but so what? I feel like OP just wanted to do this without having to spend any money and justified it (not an attack, just really trying to understand the value of it).
As the book mentions, when you buy a call, you pay for an implied borrowing cost and downside protection. Selling the put directly cancels that downside protection. So it really is a matter of cost. The call and put strategy cost about 1.8% while the call by itself was 3.9%. Since I don’t want the downside protection, I sold the put.

Not having to liquidate any positions (and pay cap gain taxes) to come up with the money to enter the position is a nice bonus but not really the reason. If the call borrowing rate had been more competitive (say 3.2-3.5%) I probably wouldn’t have sold the put.
djeayzonne wrote:
Wed Jan 08, 2020 3:09 pm

2. Somewhat related to 1.
If you truly believe in this philosophy and wanted your total stock exposure constant at the target amount as soon as possible, why wouldn't you just continue to buy a new call as soon as you had enough to buy the next one? Who cares what the leverage ratio is because your losses are limited? Who cares about the slightly higher implied interest because you would reach 100% of your target exposure as quickly as can possibly happen while keeping a sane amount of risk. What's more, as soon as you reach it, you can immediately (as soon as you have enough funds to replace one call, anyway) then start the process of deleveraging.
There’s a lot of questions here and I’m not sure what you’re asking or whether you’re talking about the book or my implementation. In order:

- As per the book, you ARE supposed to buy more calls as soon as you can.
- Higher implies borrowing rates means less profitable investments. I can achieve MORE exposure by selling the puts (because I need less money to enter the positions) while paying less interest.
djeayzonne wrote:
Wed Jan 08, 2020 3:09 pm

I feel like I'm missing something (like, Is there too much risk of the calls becoming worthless even if the market trends up depending on actual movement patterns?, etc.) because, otherwise, why wouldn't you do it this way?
Ok I think what you’re asking essentially comes down to “why keep the leverage below X value? Why not just buy as many calls as possible, with as high leverage as possible, to hit the target the soonest?”

The reason is that derivatives are in a way “callable” debt. Even just a call must eventually expire, at which point you must “rebalance” and re-establish the position. If the call is worthless, there’s nothing to show for them.

If you take out uncallable debt (say a friend loan) that you get to pay whenever, this isn’t a problem. Your net worth can dip in the negative and you can still maintain the same exposure because you still own the stocks. You aren’t forced to “come to terms with the losses” like you would with a call option.

For uncallable debt, the correct strategy is to borrow all you possibly can today and put it in the market immediately and then just service the loan the rest of your life. So that means as high leverage as you want (maybe even infinite omit your net worth dips into negative).

For callable debt, or exposure that you have to rebalance in the short term (options, futures, UPRO, etc) that might not be ideal. A small market drop might fully wipe you out and now you have NO exposure. So there’s a trade off between trying to get as much exposure now while still being able to achieve reasonable exposure in the future IF the market dips.

In the book, 2:1 leverage was about right. 3:1 still did OK but anything higher and the strategy performs worse.

User avatar
Topic Author
305pelusa
Posts: 1321
Joined: Fri Nov 16, 2018 10:20 pm

Re: Lifecycle Investing - Leveraging when young

Post by 305pelusa » Wed Jan 08, 2020 3:38 pm

ebot wrote:
Thu Jan 02, 2020 12:15 pm
Just curious why you chose to buy at the 295 strike price (when the SPY was also near 2950) instead of closer to ~50% strike as the book suggested (~145)? I'm curious because I implemented the strategy closer to 50% strike price but looking at my performance compared to yours has resulted in roughly 3x less performance (just on the call option. I didn't sell any naked puts).
Whoops I missed this question before.

If you buy a call and sell the put, the strike price actually doesn’t matter as much. Earlier in the thread, Ben Matthews made the argument that it shouldn’t matter at all. But in practice, different strike prices do produce different borrowing costs. There are reasons for that but I won’t get into it now. The leverage is basically set by how much collateral you have.

If you’re only buying the call (without the offsetting put that eliminates the downside protection) now the strike price absolutely matters. You want a strike price that is low enough that the odds of exercise are very high (delta of 1.00) to minimize the downside protection cost. But you don’t want it so low that its time value decays too quickly and you are forced into an early exercise. The strike price also sets your leverage.

The book recommends 2:1 leverage so a strike price of 50% makes sense. When goin over options, I found that a strike price at 66% (3:1 leverage) had slightly lower borrowing costs. I might recommend you look at those as well

langlands
Posts: 100
Joined: Wed Apr 03, 2019 10:05 pm

Re: Lifecycle Investing - Leveraging when young

Post by langlands » Wed Jan 08, 2020 7:22 pm

I'm not sure if this has been mentioned in this thread, but the impact of career advancement on lifecycle investing is absolutely massive. Before today, I basically thought of lifecycle investing as a way to justify taking a bit more leverage when you were younger in return for a bit less leverage in retirement. Pretty logical. But I didn't realize just how much more leverage. If your income increases so that it's always 10%+ of your net worth (and your expenses don't), it seems you could essentially stay 3x leveraged for most of your working life with a gamma of 1.

djeayzonne
Posts: 49
Joined: Wed Dec 06, 2017 2:14 pm

Re: Lifecycle Investing - Leveraging when young

Post by djeayzonne » Thu Jan 09, 2020 1:25 am

305pelusa wrote:
Wed Jan 08, 2020 3:30 pm
djeayzonne wrote:
Wed Jan 08, 2020 3:09 pm
1. I really don't understand the reason to sell the naked put. I understand the parity and that the implied interest is a bit less than just the call, but so what? I feel like OP just wanted to do this without having to spend any money and justified it (not an attack, just really trying to understand the value of it).
As the book mentions, when you buy a call, you pay for an implied borrowing cost and downside protection. Selling the put directly cancels that downside protection. So it really is a matter of cost. The call and put strategy cost about 1.8% while the call by itself was 3.9%. Since I don’t want the downside protection, I sold the put.

Not having to liquidate any positions (and pay cap gain taxes) to come up with the money to enter the position is a nice bonus but not really the reason. If the call borrowing rate had been more competitive (say 3.2-3.5%) I probably wouldn’t have sold the put.
djeayzonne wrote:
Wed Jan 08, 2020 3:09 pm

2. Somewhat related to 1.
If you truly believe in this philosophy and wanted your total stock exposure constant at the target amount as soon as possible, why wouldn't you just continue to buy a new call as soon as you had enough to buy the next one? Who cares what the leverage ratio is because your losses are limited? Who cares about the slightly higher implied interest because you would reach 100% of your target exposure as quickly as can possibly happen while keeping a sane amount of risk. What's more, as soon as you reach it, you can immediately (as soon as you have enough funds to replace one call, anyway) then start the process of deleveraging.
There’s a lot of questions here and I’m not sure what you’re asking or whether you’re talking about the book or my implementation. In order:

- As per the book, you ARE supposed to buy more calls as soon as you can.
- Higher implies borrowing rates means less profitable investments. I can achieve MORE exposure by selling the puts (because I need less money to enter the positions) while paying less interest.
djeayzonne wrote:
Wed Jan 08, 2020 3:09 pm

I feel like I'm missing something (like, Is there too much risk of the calls becoming worthless even if the market trends up depending on actual movement patterns?, etc.) because, otherwise, why wouldn't you do it this way?
Ok I think what you’re asking essentially comes down to “why keep the leverage below X value? Why not just buy as many calls as possible, with as high leverage as possible, to hit the target the soonest?”

The reason is that derivatives are in a way “callable” debt. Even just a call must eventually expire, at which point you must “rebalance” and re-establish the position. If the call is worthless, there’s nothing to show for them.

If you take out uncallable debt (say a friend loan) that you get to pay whenever, this isn’t a problem. Your net worth can dip in the negative and you can still maintain the same exposure because you still own the stocks. You aren’t forced to “come to terms with the losses” like you would with a call option.

For uncallable debt, the correct strategy is to borrow all you possibly can today and put it in the market immediately and then just service the loan the rest of your life. So that means as high leverage as you want (maybe even infinite omit your net worth dips into negative).

For callable debt, or exposure that you have to rebalance in the short term (options, futures, UPRO, etc) that might not be ideal. A small market drop might fully wipe you out and now you have NO exposure. So there’s a trade off between trying to get as much exposure now while still being able to achieve reasonable exposure in the future IF the market dips.

In the book, 2:1 leverage was about right. 3:1 still did OK but anything higher and the strategy performs worse.
Thanks for the response.

My questions are in general in contrast to the different methods of obtaining leverage.

I am still confused about the calls though. Just buying calls seems to be different from all other methods in that it is NOT callable and your losses are limited to whatever the call cost.
Why are you calling this callable?

Again, if the goal is a stabilized, constant exposure, shouldn't achieving the target as fast as possible and then deleveraging as soon as you can be worth more in the long run than worrying about the cost of borrowing now (assuming not higher than 4% anyway)?

Based on what you just said above, it still seems the only real benefit to the call/put is to achieve more exposure, no?
While at first thought, this seems like the better way to go. However, because the puts are truly callable, you can only go so far with your leverage ratio. You can go as high as you need with just calls, no? Or, am I really misunderstanding something fundamental in the way options work? Seems to good to be true, honestly.

Iridium
Posts: 543
Joined: Thu May 19, 2016 10:49 am

Re: Lifecycle Investing - Leveraging when young

Post by Iridium » Thu Jan 09, 2020 3:24 am

djeayzonne wrote:
Thu Jan 09, 2020 1:25 am
Why are you calling this callable?
Because you cannot maintain your exposure indefinitely in the presence of market losses. Let's say you bought a whole bunch of calls that expire in a year at a strike 20% below current market value. Let's say that 9 months in, the market goes down 20%. So far, so good...you still have your desired exposure (at least on the upside). However, if the market stays down, the options will expire worthless in 3 months, and your portfolio and market exposure suddenly become zero in a market when stocks are on sale. Having a bit less leverage would have kept you in the game (though at a much lower exposure than you would like). Sounds like a 2:1 ratio nicely trades off the risk reduction of hitting your desired allocation earlier with the risk that the leverage will force you to reduce exposure when stocks are on sale.

So, options aren't quite as bad as truly callable debt, in that they don't necessarily force you out of the market as soon as the market falls, but option expiration can happen at awfully inconvenient times.

User avatar
Topic Author
305pelusa
Posts: 1321
Joined: Fri Nov 16, 2018 10:20 pm

Re: Lifecycle Investing - Leveraging when young

Post by 305pelusa » Thu Jan 09, 2020 9:09 am

Iridium wrote:
Thu Jan 09, 2020 3:24 am
djeayzonne wrote:
Thu Jan 09, 2020 1:25 am
Why are you calling this callable?
Because you cannot maintain your exposure indefinitely in the presence of market losses. Let's say you bought a whole bunch of calls that expire in a year at a strike 20% below current market value. Let's say that 9 months in, the market goes down 20%. So far, so good...you still have your desired exposure (at least on the upside). However, if the market stays down, the options will expire worthless in 3 months, and your portfolio and market exposure suddenly become zero in a market when stocks are on sale. Having a bit less leverage would have kept you in the game (though at a much lower exposure than you would like). Sounds like a 2:1 ratio nicely trades off the risk reduction of hitting your desired allocation earlier with the risk that the leverage will force you to reduce exposure when stocks are on sale.

So, options aren't quite as bad as truly callable debt, in that they don't necessarily force you out of the market as soon as the market falls, but option expiration can happen at awfully inconvenient times.
I couldn’t have said it better.

User avatar
Topic Author
305pelusa
Posts: 1321
Joined: Fri Nov 16, 2018 10:20 pm

Re: Lifecycle Investing - Leveraging when young

Post by 305pelusa » Thu Jan 09, 2020 9:19 am

djeayzonne wrote:
Thu Jan 09, 2020 1:25 am
305pelusa wrote:
Wed Jan 08, 2020 3:30 pm
djeayzonne wrote:
Wed Jan 08, 2020 3:09 pm
1. I really don't understand the reason to sell the naked put. I understand the parity and that the implied interest is a bit less than just the call, but so what? I feel like OP just wanted to do this without having to spend any money and justified it (not an attack, just really trying to understand the value of it).
As the book mentions, when you buy a call, you pay for an implied borrowing cost and downside protection. Selling the put directly cancels that downside protection. So it really is a matter of cost. The call and put strategy cost about 1.8% while the call by itself was 3.9%. Since I don’t want the downside protection, I sold the put.

Not having to liquidate any positions (and pay cap gain taxes) to come up with the money to enter the position is a nice bonus but not really the reason. If the call borrowing rate had been more competitive (say 3.2-3.5%) I probably wouldn’t have sold the put.
djeayzonne wrote:
Wed Jan 08, 2020 3:09 pm

2. Somewhat related to 1.
If you truly believe in this philosophy and wanted your total stock exposure constant at the target amount as soon as possible, why wouldn't you just continue to buy a new call as soon as you had enough to buy the next one? Who cares what the leverage ratio is because your losses are limited? Who cares about the slightly higher implied interest because you would reach 100% of your target exposure as quickly as can possibly happen while keeping a sane amount of risk. What's more, as soon as you reach it, you can immediately (as soon as you have enough funds to replace one call, anyway) then start the process of deleveraging.
There’s a lot of questions here and I’m not sure what you’re asking or whether you’re talking about the book or my implementation. In order:

- As per the book, you ARE supposed to buy more calls as soon as you can.
- Higher implies borrowing rates means less profitable investments. I can achieve MORE exposure by selling the puts (because I need less money to enter the positions) while paying less interest.
djeayzonne wrote:
Wed Jan 08, 2020 3:09 pm

I feel like I'm missing something (like, Is there too much risk of the calls becoming worthless even if the market trends up depending on actual movement patterns?, etc.) because, otherwise, why wouldn't you do it this way?
Ok I think what you’re asking essentially comes down to “why keep the leverage below X value? Why not just buy as many calls as possible, with as high leverage as possible, to hit the target the soonest?”

The reason is that derivatives are in a way “callable” debt. Even just a call must eventually expire, at which point you must “rebalance” and re-establish the position. If the call is worthless, there’s nothing to show for them.

If you take out uncallable debt (say a friend loan) that you get to pay whenever, this isn’t a problem. Your net worth can dip in the negative and you can still maintain the same exposure because you still own the stocks. You aren’t forced to “come to terms with the losses” like you would with a call option.

For uncallable debt, the correct strategy is to borrow all you possibly can today and put it in the market immediately and then just service the loan the rest of your life. So that means as high leverage as you want (maybe even infinite omit your net worth dips into negative).

For callable debt, or exposure that you have to rebalance in the short term (options, futures, UPRO, etc) that might not be ideal. A small market drop might fully wipe you out and now you have NO exposure. So there’s a trade off between trying to get as much exposure now while still being able to achieve reasonable exposure in the future IF the market dips.

In the book, 2:1 leverage was about right. 3:1 still did OK but anything higher and the strategy performs worse.
Thanks for the response.

My questions are in general in contrast to the different methods of obtaining leverage.

I am still confused about the calls though. Just buying calls seems to be different from all other methods in that it is NOT callable and your losses are limited to whatever the call cost.
Why are you calling this callable?

Again, if the goal is a stabilized, constant exposure, shouldn't achieving the target as fast as possible and then deleveraging as soon as you can be worth more in the long run than worrying about the cost of borrowing now (assuming not higher than 4% anyway)?

Based on what you just said above, it still seems the only real benefit to the call/put is to achieve more exposure, no?
While at first thought, this seems like the better way to go. However, because the puts are truly callable, you can only go so far with your leverage ratio. You can go as high as you need with just calls, no? Or, am I really misunderstanding something fundamental in the way options work? Seems to good to be true, honestly.
I shouldn’t have called it “callable”, that confused you and it’s wrong any ways. I meant to say that calls force you to “rebalance” on a short term (relative to your life) calendar schedule. That means that now there’s a trade off between achieving less exposure now in order to ensure you can maintain a little more even exposure in the future after a severe drop.

Either way, if you use calls alone and you keep the borrowing cost below 4%, then that limits you to about 2-3:1 leverage any ways which is what the book recommends 0_o

djeayzonne
Posts: 49
Joined: Wed Dec 06, 2017 2:14 pm

Re: Lifecycle Investing - Leveraging when young

Post by djeayzonne » Thu Jan 09, 2020 3:13 pm

305pelusa wrote:
Thu Jan 09, 2020 9:19 am
[

Either way, if you use calls alone and you keep the borrowing cost below 4%, then that limits you to about 2-3:1 leverage any ways which is what the book recommends 0_o
I think this must be what I'm missing.
The implication here is that buying more calls increases the borrowing cost percentage. I don't understand why that is.
My understanding is that each call is a separate 'loan' with each one having an implied interest rate of less than 4%.
I would appreciate if you can explain your last statement with a bit more detail!

Thanks again for this awesome thread.

User avatar
Topic Author
305pelusa
Posts: 1321
Joined: Fri Nov 16, 2018 10:20 pm

Re: Lifecycle Investing - Leveraging when young

Post by 305pelusa » Thu Jan 09, 2020 3:27 pm

djeayzonne wrote:
Thu Jan 09, 2020 3:13 pm
305pelusa wrote:
Thu Jan 09, 2020 9:19 am
[

Either way, if you use calls alone and you keep the borrowing cost below 4%, then that limits you to about 2-3:1 leverage any ways which is what the book recommends 0_o
I think this must be what I'm missing.
The implication here is that buying more calls increases the borrowing cost percentage. I don't understand why that is.
My understanding is that each call is a separate 'loan' with each one having an implied interest rate of less than 4%.
I would appreciate if you can explain your last statement with a bit more detail!

Thanks again for this awesome thread.
If you have 100k, and you’re supposed to hit 1M exposure, you’d need 10x leverage. That requires calls with strike price around 90% of the index. Those calls have a very reasonable probability of expiring out of the money (delta < 1). This means the market will price a significant downside protection premium because there’s a very good chance it will kick in. This increases the borrowing cost a lot. That’s what the book means when they say “high leverage gets expensive quickly”.

Obviously if you could get arbitrarily high leverage just with calls at 4%, then you should just hit your desired exposure. Even if the options expire worthless, just grab some savings contributions and leverage them arbitrarily to establish your exposure once again. Since they have downside protection and non-callability (that is free in this hypothetical example) then who cares? It’s like leveraging with mortgage debt at that point.

In the real world, leverage higher than 2-3 with just calls and noncallability gets too expensive. And if you use futures and put-call parity, you can get arbitrarily high leverage at the same borrowing cost throughout but now are subject to callability. If the market drops enough, you’rewiped out and can’t re-establish your exposure

djeayzonne
Posts: 49
Joined: Wed Dec 06, 2017 2:14 pm

Re: Lifecycle Investing - Leveraging when young

Post by djeayzonne » Thu Jan 09, 2020 3:50 pm

Ok, I think we are talking about slightly different approaches.
I'm not talking about an individual call at 10:1 leverage.
I'm talking about buying like one or two calls a month that is between 2:1 to 3:1 leverage continuously until you hit the target exposure.

More practically, I'm considering maintaining my 30% AA in international and then spitting the remainder 50% calls and 50% what I'm already investing in.

That would still work out to about a call a month.

User avatar
Topic Author
305pelusa
Posts: 1321
Joined: Fri Nov 16, 2018 10:20 pm

Re: Lifecycle Investing - Leveraging when young

Post by 305pelusa » Thu Jan 09, 2020 4:08 pm

djeayzonne wrote:
Thu Jan 09, 2020 3:50 pm
Ok, I think we are talking about slightly different approaches.
I'm not talking about an individual call at 10:1 leverage.
I'm talking about buying like one or two calls a month that is between 2:1 to 3:1 leverage continuously until you hit the target exposure.
That’s exactly what the book recommends. That’s what I meant when I said:
305pelusa wrote:
Wed Jan 08, 2020 3:30 pm
- As per the book, you ARE supposed to buy more calls as soon as you can.

djeayzonne
Posts: 49
Joined: Wed Dec 06, 2017 2:14 pm

Re: Lifecycle Investing - Leveraging when young

Post by djeayzonne » Thu Jan 09, 2020 9:11 pm

Cool. Thanks so much for being patient with me.

djeayzonne
Posts: 49
Joined: Wed Dec 06, 2017 2:14 pm

Re: Lifecycle Investing - Leveraging when young

Post by djeayzonne » Sat Jan 11, 2020 5:20 am

Is there anyway to also do something similar with international?

I just did a little research on my own, and it seems options on IXUS are available,
but virtually no interest and the farthest out is October of this year.

redstar
Posts: 60
Joined: Thu Jul 13, 2017 11:15 pm

Re: Lifecycle Investing - Leveraging when young

Post by redstar » Tue Jan 14, 2020 1:06 pm

I've been interested in Lifecycle Investing for about 3 years or so, but have recently read the book and become interested again. I'd like to start paper trading to get the hang of LEAPs and/or futures. Can anyone recommend a brokerage that has good paper trading accounts for options and futures?

EfficientInvestor
Posts: 268
Joined: Thu Nov 01, 2018 7:02 pm
Location: Alabama

Re: Lifecycle Investing - Leveraging when young

Post by EfficientInvestor » Tue Jan 14, 2020 1:13 pm

djeayzonne wrote:
Sat Jan 11, 2020 5:20 am
Is there anyway to also do something similar with international?

I just did a little research on my own, and it seems options on IXUS are available,
but virtually no interest and the farthest out is October of this year.
If you are wanting to get international exposure in addition to US exposure, you could just hold something like IXUS directly and then get your leverage on the US equities side.

Lee_WSP
Posts: 1410
Joined: Fri Apr 19, 2019 5:15 pm
Location: Arizona

Re: Lifecycle Investing - Leveraging when young

Post by Lee_WSP » Tue Jan 14, 2020 3:59 pm

Is the issue against a fund like PSLDX the expense ratio? Because based on the prospectus, it does not reset daily and seems to try to emulate a 100% equities, 100% LTT, & -100% LIBOR cash portfolio.

UberGrub
Posts: 113
Joined: Wed Aug 21, 2019 3:47 pm

Re: Lifecycle Investing - Leveraging when young

Post by UberGrub » Tue Jan 14, 2020 4:02 pm

Lee_WSP wrote:
Tue Jan 14, 2020 3:59 pm
Is the issue against a fund like PSLDX the expense ratio? Because based on the prospectus, it does not reset daily and seems to try to emulate a 100% equities, 100% LTT, & -100% LIBOR cash portfolio.
Because it doesn’t get you any closer to your target equity exposure than VTI does.

Lee_WSP
Posts: 1410
Joined: Fri Apr 19, 2019 5:15 pm
Location: Arizona

Re: Lifecycle Investing - Leveraging when young

Post by Lee_WSP » Tue Jan 14, 2020 4:11 pm

UberGrub wrote:
Tue Jan 14, 2020 4:02 pm
Lee_WSP wrote:
Tue Jan 14, 2020 3:59 pm
Is the issue against a fund like PSLDX the expense ratio? Because based on the prospectus, it does not reset daily and seems to try to emulate a 100% equities, 100% LTT, & -100% LIBOR cash portfolio.
Because it doesn’t get you any closer to your target equity exposure than VTI does.
Interesting reasoning. So the leverage must get you to greater than 100% equities as opposed to leverage the entire portfolio?

Walkure
Posts: 148
Joined: Tue Apr 11, 2017 9:59 pm

Re: Lifecycle Investing - Leveraging when young

Post by Walkure » Tue Jan 14, 2020 4:31 pm

djeayzonne wrote:
Thu Jan 09, 2020 3:50 pm
Ok, I think we are talking about slightly different approaches.
I'm not talking about an individual call at 10:1 leverage.
I'm talking about buying like one or two calls a month that is between 2:1 to 3:1 leverage continuously until you hit the target exposure.

More practically, I'm considering maintaining my 30% AA in international and then spitting the remainder 50% calls and 50% what I'm already investing in.

That would still work out to about a call a month.
Right, but if you have a 2:1 option from last month. and this month you use new money to buy another 2:1 option, you are not magically at a total leverage of 4:1 - it's still just 2:1 with twice the collateral (option premium) at stake. Using this method without selling the put will take substantially longer to hit your target number.

UberGrub
Posts: 113
Joined: Wed Aug 21, 2019 3:47 pm

Re: Lifecycle Investing - Leveraging when young

Post by UberGrub » Tue Jan 14, 2020 4:54 pm

Lee_WSP wrote:
Tue Jan 14, 2020 4:11 pm
UberGrub wrote:
Tue Jan 14, 2020 4:02 pm
Lee_WSP wrote:
Tue Jan 14, 2020 3:59 pm
Is the issue against a fund like PSLDX the expense ratio? Because based on the prospectus, it does not reset daily and seems to try to emulate a 100% equities, 100% LTT, & -100% LIBOR cash portfolio.
Because it doesn’t get you any closer to your target equity exposure than VTI does.
Interesting reasoning. So the leverage must get you to greater than 100% equities as opposed to leverage the entire portfolio?
Im not sure what you’re saying. The point of lifecycle investing is to over invest in stocks (past 100% exposure to equities) because you’re so invested in “bonds” via your human capital.

Lee_WSP
Posts: 1410
Joined: Fri Apr 19, 2019 5:15 pm
Location: Arizona

Re: Lifecycle Investing - Leveraging when young

Post by Lee_WSP » Tue Jan 14, 2020 5:04 pm

UberGrub wrote:
Tue Jan 14, 2020 4:54 pm
Lee_WSP wrote:
Tue Jan 14, 2020 4:11 pm
UberGrub wrote:
Tue Jan 14, 2020 4:02 pm
Lee_WSP wrote:
Tue Jan 14, 2020 3:59 pm
Is the issue against a fund like PSLDX the expense ratio? Because based on the prospectus, it does not reset daily and seems to try to emulate a 100% equities, 100% LTT, & -100% LIBOR cash portfolio.
Because it doesn’t get you any closer to your target equity exposure than VTI does.
Interesting reasoning. So the leverage must get you to greater than 100% equities as opposed to leverage the entire portfolio?
Im not sure what you’re saying. The point of lifecycle investing is to over invest in stocks (past 100% exposure to equities) because you’re so invested in “bonds” via your human capital.
Yes, that was my question.

I still think PSLDX satisfies the spirit of leveraging while young, but I get it.

ChrisBenn
Posts: 41
Joined: Mon Aug 05, 2019 7:56 pm

Re: Lifecycle Investing - Leveraging when young

Post by ChrisBenn » Tue Jan 14, 2020 6:13 pm

UberGrub wrote:
Tue Jan 14, 2020 4:54 pm
Lee_WSP wrote:
Tue Jan 14, 2020 4:11 pm
(...)
Interesting reasoning. So the leverage must get you to greater than 100% equities as opposed to leverage the entire portfolio?
Im not sure what you’re saying. The point of lifecycle investing is to over invest in stocks (past 100% exposure to equities) because you’re so invested in “bonds” via your human capital.
So huge caveat in that I haven't read the book - only inferred things about it from this thread and discussion ...

... but, is it (lifecycle investing) really about only equity exposure specifically, or is narrative mostly focused on that because that's what you can get efficient leverage on at the individual investor level?

Wouldn't the standard MPT / leverage best risk adjusted return / etc. mantra still apply; one would just leverage it past the same volatility as straight equities (i guess, ideally, to the same volatility as your target equity exposure under lifecycle).

Now how feasible at the individual investor level this is is another issue, and I fully concede that logistics may make this a non-starter - but from the lifecycle investing POV this wouldn't be wrong, would it? If ones "end state" portfolio was a 50/50 portfolio @ 2 mil then once one had 1 mil of psdlx they would actually start divesting of it for a non-leveraged 50/50 portfolio as gains accumulated, right? Or did something in the book limit this only to equities?

User avatar
Topic Author
305pelusa
Posts: 1321
Joined: Fri Nov 16, 2018 10:20 pm

Re: Lifecycle Investing - Leveraging when young

Post by 305pelusa » Tue Jan 14, 2020 6:28 pm

ChrisBenn wrote:
Tue Jan 14, 2020 6:13 pm
UberGrub wrote:
Tue Jan 14, 2020 4:54 pm
Lee_WSP wrote:
Tue Jan 14, 2020 4:11 pm
(...)
Interesting reasoning. So the leverage must get you to greater than 100% equities as opposed to leverage the entire portfolio?
Im not sure what you’re saying. The point of lifecycle investing is to over invest in stocks (past 100% exposure to equities) because you’re so invested in “bonds” via your human capital.
So huge caveat in that I haven't read the book - only inferred things about it from this thread and discussion ...

... but, is it (lifecycle investing) really about only equity exposure specifically, or is narrative mostly focused on that because that's what you can get efficient leverage on at the individual investor level?

Wouldn't the standard MPT / leverage best risk adjusted return / etc. mantra still apply; one would just leverage it past the same volatility as straight equities (i guess, ideally, to the same volatility as your target equity exposure under lifecycle).

Now how feasible at the individual investor level this is is another issue, and I fully concede that logistics may make this a non-starter - but from the lifecycle investing POV this wouldn't be wrong, would it? If ones "end state" portfolio was a 50/50 portfolio @ 2 mil then once one had 1 mil of psdlx they would actually start divesting of it for a non-leveraged 50/50 portfolio as gains accumulated, right? Or did something in the book limit this only to equities?
This is a point raised by EfficientInvestor. Here’s a slightly different take on why I disagree with it:

At its core, Lifecycle Investing is about having a constant allocation to various asset classes (and risk premiums) through your life. So what to leverage depends entirely on what you consider your salary to be, since you want to leverage whatever your salary is not and cancel it out.

If you believe your salary is cash, and your desired portfolio is, say, 50/50 stock/bonds, then clearly the correct thing is to leverage stocks and bonds and short cash. This is what PLDSX would do.

However, my salary is indisputably more of a bond than cash. The present value of my future savings DOES vary with interest rates (in fact, that’s how it’s calculated) just like bonds do. The present value of my future savings also has a duration, which can be calculated by the timing of the contributions. Cash has neither duration nor susceptibility to interest rates.

So in my view, I’m massively exposed to interest rate changes already. My job IS a bond, not cash.

The correct strategy for me is to short bonds (take out a long term loan) and invest in equities. However, long term loans are hard to come by. So I do the next best thing and short cash/LIBOR and invest that in stocks.

In fact, in my view, PSLDX is not only not getting me closer to my higher equity goal than VTI (while carrying an outrageous fee) but it’s also giving me further interest rate and bond exposure than what I want.

Just my view

UberGrub
Posts: 113
Joined: Wed Aug 21, 2019 3:47 pm

Re: Lifecycle Investing - Leveraging when young

Post by UberGrub » Tue Jan 14, 2020 6:41 pm

305 thank you for an excellent response. That makes a ton of sense.
305pelusa wrote:
Tue Jan 14, 2020 6:28 pm

The correct strategy for me is to short bonds (take out a long term loan) and invest in equities.
A bulb just clicked in my head. The exact way to offset ones salary is to take out a zero-coupon loan that matures exactly in every payday. If you did that for every payday in your life, you’d cancel your salary exactly. So your salary is really nothing more than hundreds of zero coupon bonds all expiring every other week.

Which is exactly how you calculate its present value. I’m mind blown right now. I’m definitely sold on this thinking.

Lee_WSP
Posts: 1410
Joined: Fri Apr 19, 2019 5:15 pm
Location: Arizona

Re: Lifecycle Investing - Leveraging when young

Post by Lee_WSP » Tue Jan 14, 2020 6:47 pm

Something just feels off about thinking of salary as a bond. Perhaps its because I don't feel as though I'm guaranteed a salary in the first place. Ie, I/we/you could get laid off or be incapacitated (as black swan as it is, I think layoffs disastrous enough and likely enough that it's more of a known risk).

Is it the duration exposure that makes one want to short cash vs short bonds?

User avatar
Topic Author
305pelusa
Posts: 1321
Joined: Fri Nov 16, 2018 10:20 pm

Re: Lifecycle Investing - Leveraging when young

Post by 305pelusa » Tue Jan 14, 2020 6:57 pm

Lee_WSP wrote:
Tue Jan 14, 2020 6:47 pm
Something just feels off about thinking of salary as a bond. Perhaps its because I don't feel as though I'm guaranteed a salary in the first place. Ie, I/we/you could get laid off or be incapacitated (as black swan as it is, I think layoffs disastrous enough and likely enough that it's more of a known risk).

Is it the duration exposure that makes one want to short cash vs short bonds?
That’s fine. I don’t think my salary is perfectly safe. I’ve assigned it as a 20/80 stock/bond source. Since my ideal portfolio is 50/50, I still need to use Lifecycle Investing.

Note that most bonds aren’t perfectly safe either. Except for treasuries, they all have different levels of credit risk. So just because a bond or salary isn’t perfectly safe doesn’t mean it cannot be thought of as a bond. It’s just a bond with some credit (“stockiness”) risk.

As to your second question: You want to short whatever your salary is. Because my salary’s value is practically the same as a bond (as Ubergrub just showed, it’s just a bunch of zero coupon bonds with some credit risk), I want to short bonds. Ideally bonds of the same duration and credit worthiness as my job.

I could use futures to short bonds and I’ve thought about it but haven’t pulled the trigger. Shorting cash is as far as I’vegone. But I certainly don’t want MORE bond exposure with something like PSLDX

ChrisBenn
Posts: 41
Joined: Mon Aug 05, 2019 7:56 pm

Re: Lifecycle Investing - Leveraging when young

Post by ChrisBenn » Tue Jan 14, 2020 7:30 pm

305pelusa wrote:
Tue Jan 14, 2020 6:28 pm
At its core, Lifecycle Investing is about having a constant allocation to various asset classes (and risk premiums) through your life. So what to leverage depends entirely on what you consider your salary to be, since you want to leverage whatever your salary is not and cancel it out.
(...)
Thanks for this (and the rest as well) - that helps me reconcile my understanding with some of the discussion here. I had previously understood it from the temporal diversification standpoint - that seemed very intuitive - but didn't quite account for the extreme equity focus (i.e. should apply to any portfolio / exposure to risk). I get now that the logical next step is just an extension of the existing discussion in literature on how to model human capital.

Two follow-ups/clarifications:

* As one progresses through their lifecycle they should add bonds (or whatever basket of assets you modeled your human capital as) back in (i.e. as their human capital becomes exhausted) to keep the total exposure the same, correct?

* I'm still not intuiting the exposure to interest rate risk via human capital. From a model standpoint (calculating the present discounted value of future salary) one would use a return rate -- but really that return rate is correlated to an asset class; so I don't think it's fair to say that human capital inherently has interest rate risk - unless the asset class you derived your return rate from has interest rate risk? Or another way, is the salary more like a short term bond (2 week zero coupon), or long term bond? I would imagine the former. Now if you want interest rate risk/premium in your exposures is a fair question, and I think not a given; I'm just not intuiting how it would already be incorporated in human capital.

User avatar
Topic Author
305pelusa
Posts: 1321
Joined: Fri Nov 16, 2018 10:20 pm

Re: Lifecycle Investing - Leveraging when young

Post by 305pelusa » Tue Jan 14, 2020 8:15 pm

ChrisBenn wrote:
Tue Jan 14, 2020 7:30 pm
Two follow-ups/clarifications:

* As one progresses through their lifecycle they should add bonds (or whatever basket of assets you modeled your human capital as) back in (i.e. as their human capital becomes exhausted) to keep the total exposure the same, correct?
Absolutely. As time goes by, you will leverage less until you're fully deleveraged and 100% in stocks. After that, every dollar of income would be invested into a dollar of bonds as a simple transfer from human capital to bond capital.
ChrisBenn wrote:
Tue Jan 14, 2020 7:30 pm
From a model standpoint (calculating the present discounted value of future salary) one would use a return rate -- but really that return rate is correlated to an asset class; so I don't think it's fair to say that human capital inherently has interest rate risk - unless the asset class you derived your return rate from has interest rate risk?
I'm just thinking of interest rate being the fundamental time value of money. Every other return (be it private equity, stocks, etc) are simply risk premiums on top of that value of money:
Scenario 1: Boss says he'll pay me a 10k bonus one year from today. The 1 year treasury rate is at 10%.
Scenario 2: Boss again says he'll pay me a 10k bonus one year from today. The 1 year treasury rate is at 0%.

I think it's reasonable for me to believe the compensation in scenario 1 is worth less. Not just from an inflationary standpoint, but even from a "time value of money" standpoint. As for my boss, it is less difficult for him to meet the liability in scenario 1 than 2. He would need a smaller investment/less income to meet it.

That said, I don't think it's only interest rate risk. Your point about "being a return" is true. So I simply use a blended 20/80 stock/bond rate. If someone sold "305pelusa salary bonds" that correlated perfectly with my job and has the exact magnitude and timing of payments, I'd prefer to short that!
ChrisBenn wrote:
Tue Jan 14, 2020 7:30 pm
Or another way, is the salary more like a short term bond (2 week zero coupon), or long term bond?
I think of my salary is simply a series of hundreds of zero coupon bonds, with maybe inflation protection, all maturing two weeks after the previous one, with some credit risk. Is it exactly that? No. But it matches up reasonably well with the assets I have. It's certainly closer to that than straight cash IMO.

ChrisBenn wrote:
Tue Jan 14, 2020 7:30 pm
I'm just not intuiting how it would already be incorporated in human capital.
It's not a perfect analogy by any means and if you have better thoughts, I'm certainly all ears. My point is simply that I think it's more reasonable to think of a salary as some blend of stocks and bonds with long term durations, than cash. That's also what the lifecycle investing theory and formulas assume and I don't want to reinvent this kind of theory.

If you personally believe it's more reasonable to model as cash, then leverage a balanced portfolio. Many here in BHs do. I don't think there's a right or wrong. I'm just following what's logical and makes sense to me.

Post Reply