Long call as substitute for geared portfolio

OmegaTrader said:

I think this is of topic enough.

Sorry for my part to the original poster.

THIS IS NOT ADVICE

I think my last word would be on what I would do.

Do the analysis see which is cheaper taking into account the relevant factors and compare the strategies performance. Dividends, borrowing rate, volatility/implied volatility, tax, transactional costs etc etc


Look at the past results and look at the current prices. Understand what an option is .

Gear at an amount between what my comfortable level is and the sweet spot determined from the analysis/current prices/conditions.

Invest what I would afford based on my net worth.

Recognise that however small their is a counter-party risk. That a derivative is not an asset like a house or a car or a company I own, but is only as good as the solvency of the counter-party.

Then make the decision based on the circumstances.

The irony of the decision is that either way the critical assumption is whether buy and hold will continue to work in the long term.

That depends on Australia.


Good luck

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Thanks for the comments OmegaTrader!

Regarding the "off-topic" discussion, I think if it gets to the stage where an exchange fails, I'd probably be more comfortable losing the $2.5k option contract I bought than if I have a $60k portfolio at risk in that market!

EIB said:

Thanks for the detailed reply DeepState! Options being priced at the interbank rate explains the cheaper cost of carry. Does seem like an alternative way to access better financing rates than typical retail loans.

Curious as to why you think it's better to simply use cash if we have to be prepared in the worst case scenario to see falls of 60%. Wouldn't it be better to buy an option for $2.5k, keep the rest of my cash in the bank/term deposit and if the market crashes and burns, all I've lost is the $2.5k versus potentially seeing the $60k portfolio I bought with cash fall down to a value of $24k? Just wanted to clarify that if I have $60k in cash, the choice for me isn't whether to buy $60k worth of ETFs or to buy $60k worth of options. I would only invest into options what I'm prepared to lose.

Haven't looked into levered ETFs before so will definitely do some research on them! But continuing on the point above, if I buy levered ETFs straight out with cash, whilst my upside is magnified, it also magnifies my potential losses. With a call option, I've got downside protection and only stand to lose the cost of the option? If the cost of the option seems cheaper than a margin loan or even similar to bank cash interest rate at 2-3% it just seems like a smarter way to add leverage to your portfolio as you get to maximise the upside whilst protecting yourself from the downside of leverage where you magnify your losses.

Also in terms of valuing the outcomes as at the expiration date, if I'm planning on rolling the option at the money for another 1-2 years, wouldn't the outcome be the same as if you paid for the full portfolio value in cash, then sell it on the expiration date and buy back in at the exact same price and hold for another 1-2 years? The cost of the option would again simply be seen as a financing cost for whatever period the option is for. Of course there's the chance that option prices could be much higher if volatility increases. Is there somewhere I can see historical option prices?

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Options provide certainty about maximum losses. The key issue is that they provide certainty at expiration dates when what you really want is to protect against maximum losses at some horizon which doesn't match this and is often a lot longer dated.

Probablistically, you are much better off buying a portfolio of stocks and holding them for a long time (assuming you think the return is greater than cash overall) than holding a bunch of rolling ATM options for equivalent delta hedge (equivalent sensitivity to the movement of the index) at initiation of new options contracts. This is because you are paying for protection along the way as opposed to protection for some really long term objective. Assume options are fair priced.

Naturally, there are cases where a terrible bear market can come in to play. In such scenarios, the rolling call options work better. But, probablistically, it is not a good move to make. This is for a cash portfolio or cash plus options alternative which is matched for equivalent sensitivity to the market at options roll dates. If you are concerned about terrible outcomes, the better thing to do is to invest in cash portfolios and buy put protection over a long time frame at a level which matters for you. Protection is then cheapest and most relevant to you. This is the case whether you choose to invest via cash or lever. The only exception is that you really care about payoffs at expirations on the calls. It doesn't seem that you do. In reality, it's cheaper still to whack some futures stops on at levels that matter to you for such purposes. That's allowing for the fact that a stop is also a form of option.

DeepState said:

Options provide certainty about maximum losses. The key issue is that they provide certainty at expiration dates when what you really want is to protect against maximum losses at some horizon which doesn't match this and is often a lot longer dated.

Probablistically, you are much better off buying a portfolio of stocks and holding them for a long time (assuming you think the return is greater than cash overall) than holding a bunch of rolling ATM options for equivalent delta hedge (equivalent sensitivity to the movement of the index) at initiation of new options contracts. This is because you are paying for protection along the way as opposed to protection for some really long term objective. Assume options are fair priced.

Naturally, there are cases where a terrible bear market can come in to play. In such scenarios, the rolling call options work better. But, probablistically, it is not a good move to make. This is for a cash portfolio or cash plus options alternative which is matched for equivalent sensitivity to the market at options roll dates. If you are concerned about terrible outcomes, the better thing to do is to invest in cash portfolios and buy put protection over a long time frame at a level which matters for you. Protection is then cheapest and most relevant to you. This is the case whether you choose to invest via cash or lever. The only exception is that you really care about payoffs at expirations on the calls. It doesn't seem that you do. In reality, it's cheaper still to whack some futures stops on at levels that matter to you for such purposes. That's allowing for the fact that a stop is also a form of option.

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Would your analysis change if instead of looking to put $57.5k in cash and buying a $2.5k option to give me an equivalent $60k exposure, I was to buy $57.5k ETF portfolio and buy a $2.5k option to essentially double my exposure to c.$120k if I believe the market will outperform the current 2-3%p.a. it's currently costing me to pay for the options?

I get your point around unnecessarily paying for protection along the way. However, if I take the option purely as a financing instrument it seems like it's currently cheaper for me to finance a portfolio via options than via a retail margin loan and I'm essentially getting the option protection for free.

EIB said:

Just wanted to know how you're calculating the 5% premium? If it's the option price divided by the exercise price than it's closer to 4.1% which is cheaper than the cheapest margin loan I can find of 4.9%. Also if I look for a even longer dated option (Sep 18 with strike of 5850) it seems to cost 215 so effective finance cost seems to be c.2.5% p.a.? Just wanted to see whether I'm miscalculating something here.

Missing out on the dividends obviously is a big factor. But it seems to be offset somewhat by the cheaper financing costs compared to a margin loan. Alternatively if I was planning on financing the $60k portfolio using all cash than it would be somewhat offset by being able to put c.$57.5k in the bank c.2.9% p.a. and only paying the option premium price.

Also if I was to buy ETFs instead I would most likely have majority overseas ETFs e.g. europe, US, emerging markets etc which I'm more bullish on than the ASX. They seem to have lower yields and no franking benefits so missing out on the dividends would be less of a factor. So ideally I'd be looking to apply this strategy to overseas index options if that's possible?

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Missed this earlier, 5% calc is 4.1% as you have; However thats only till March. Also added in a bit from spread and liq considerations

Most of the other stuff has been covered, feel free to ask if there's anything else.

You could also look at GEAR AU - its a 2x leveraged ETF that seeks to replicate 2x long term performance of the ASX200 (which is a distinct difference from the 2x and 3x ETFs in the US which suffers from path dependency/decay)

EIB said:

Thanks for the comments OmegaTrader!

Regarding the "off-topic" discussion, I think if it gets to the stage where an exchange fails, I'd probably be more comfortable losing the $2.5k option contract I bought than if I have a $60k portfolio at risk in that market!

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good luck!

Analyse well and don't over gear

cheers

EIB said:

buying a $2.5k option to give me an equivalent $60k exposure

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Except at expiry, you can't value an option for the equivalent exposure to an amount of stock.

EIB said:

Would your analysis change if instead of looking to put $57.5k in cash and buying a $2.5k option to give me an equivalent $60k exposure, I was to buy $57.5k ETF portfolio and buy a $2.5k option to essentially double my exposure to c.$120k if I believe the market will outperform the current 2-3%p.a. it's currently costing me to pay for the options?

I get your point around unnecessarily paying for protection along the way. However, if I take the option purely as a financing instrument it seems like it's currently cheaper for me to finance a portfolio via options than via a retail margin loan and I'm essentially getting the option protection for free.

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Let's say there is merit to the idea of using options vs borrowing at retail levels and investing in ETFs. There is less merit is using options if you invest in levered ETFs.

An option premium is not an insurance payment. It is the payment you make to receive the option payoff as at expiration date. Buying an ATM option does not give you the same economic exposure as buying the underlying index. It's more like half.

If you think the market is going to go down...don't buy equities. If you are sure the market is going to go up, buy futures.

If you are long term and have around half the money you want to invest, buy the GEAR-ASX fund and whack on stops to limit your losses whilst gaining the exposure you seem to want. There are all sorts of trade-offs on the exposure and stops as it is.

If you use options, you will miss out on franking and pay for profits on your income account. If your tax rate is 50% ... you keep franking and pay for cap gains on realisation only and on concessional rates if >12 months. All of these things basically close down the financing margin anyway let alone the over-insurance arising from rolling contracts.

Just use the (un)geared ETFs and put stops on. If you have to borrow for the whole lot or want to punt on borrowed money, it's not really investing for the long term and options generally consume more capital than futures plus stops unless you really want the precise payoff.

Just keep it simple and linear.


Disclosure: holder of Betashares product and other index ASX exposures. All statements for general, illustrative, purposes for a hypothetical situation.

DeepState said:

Let's say there is merit to the idea of using options vs borrowing at retail levels and investing in ETFs. There is less merit is using options if you invest in levered ETFs.

An option premium is not an insurance payment. It is the payment you make to receive the option payoff as at expiration date. Buying an ATM option does not give you the same economic exposure as buying the underlying index. It's more like half.

If you think the market is going to go down...don't buy equities. If you are sure the market is going to go up, buy futures.

If you are long term and have around half the money you want to invest, buy the GEAR-ASX fund and whack on stops to limit your losses whilst gaining the exposure you seem to want. There are all sorts of trade-offs on the exposure and stops as it is.

If you use options, you will miss out on franking and pay for profits on your income account. If your tax rate is 50% ... you keep franking and pay for cap gains on realisation only and on concessional rates if >12 months. All of these things basically close down the financing margin anyway let alone the over-insurance arising from rolling contracts.

Just use the (un)geared ETFs and put stops on. If you have to borrow for the whole lot or want to punt on borrowed money, it's not really investing for the long term and options generally consume more capital than futures plus stops unless you really want the precise payoff.

Just keep it simple and linear.


Disclosure: holder of Betashares product and other index ASX exposures. All statements for general, illustrative, purposes for a hypothetical situation.

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Can you explain a bit more on what an effective stop strategy would look like? Isn't there a big risk that you stop yourself out just before the market rallies? How would you know when to buy back in? It seems like using that strategy would require trying to time the market and it's something I wouldn't really back myself doing consistently. I could see it easily falling into a trap of selling low and buying high using a stop loss strategy even though a stop is free. With options, I can ride out the volatility until expiry and if it's still OTM at expiry, I've limited my losses and I can roll over with another option at the a lower ATM strike price and benefit from a potential rally effectively rebalancing the portfolio?

I expect the market to go up over time but I certainly don't expect it to do it in a linear fashion and there's every chance of a major downturn that I wouldn't be able to predict. If the option premium effectively costs 2-3% p.a., I would definitely expect the market to return better than that otherwise I wouldn't be investing at all. It seems to make sense to me under that scenario to maximise leverage and take advantage of the bull market periods and during the bear market periods to limit my losses to the option premium which I can easily finance?

Can you please be very specific so we can talk about the exact same situation:

What is the amount of money you actually want to put in to the markets? $60k notional?

Do you have the money for this or does it have to be financed in whole or in part? What is the exact figure?

What is your relevant tax rate and situation? Aust tax resident? Corporate etc?

What is the time frame over which these investments are supposed to be regarded as working for you? 10 years?

Acknowledging that there is risk, even with a series of rolling options that consistently expire out of the money, what is the maximum loss that you can sustain over the time frame? $30k?

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The idea of the stop is that, over the time frame you cared about, once touched...your done.

The compound return of a series of options that actually provides the same exposure you want will be materially below that of the buy-hold alternative. In the longer run, the full range of outcomes even applying a series of call options looks sort of like the outcomes if you didn't do anything with options and just buy-hold - except lower.

There is a misconception that the premium is the price for insurance. There is also a misconception that this 3% figure represents the price to get an exposure to the market as per the full $60k. The figure is closer to double that.

Whack a stop at the point where you simply tap out of the market. Simple. It should be really wide or you really shouldn't be in the market at all. It is true that the market can touch the stop and then bounce back. Leaving you out of the rebound. Probablistically, the stop does reduce your expected return for such reasons...which is the implied cost of that insurance. But it is much smaller than for a series of options rolled sequentially as proposed. An alternative is to ladder the stops to reduce this probability.

It takes some modelling to demonstrate all of this. Perhaps you might build a model and explain how it works and your conclusions to the thread. Hopefully the ASF crew can guide you along.

Except in the most unusual situations for a long term investor at Australian tax rates for an individual, you will end up with ETFs plus stops.

Nice one DS.

EIB. It is rather hard to explain to you the intricacies of options when you don't quite have the full knowledge of options, how they are priced and how they work.

You need to understand Delta, intrinsic and extrinsic value, volatility and to a lesser extent Gamma.

Once you have an understanding of these very important pillars, the explanation by DS makes more sense.

And for the record, options can be used to reduce risk, or Delta, whilst your shares work for you.

Lastly, DS's idea of the ETF is a damn good one.