The following is a bit of a tangent, but it's relevant to leveraged investing.
The following paper looked at leverage in the Canadian stock market from 1950 to 2001. Based on their assumptions, the optimal leverage ratio was found to be 241%. But one of their assumptions is that one can borrow at the 91 day government of Canada Treasury bill rate. As the authors point out, the prime rate is usually around 1% above the T bill rate, and margin loan rates are around 1% above the prime rate. When they run the numbers again using an interest rate 2% greater than the T bill rate, the optimal leverage ratio is 157%.
http://www.fsa.ulaval.ca/nfa2003/papier ... Wilson.pdf
Another way to obtain leverage is deep in the money calls. In tax advantaged accounts, margin lending is not possible, but deep in the money calls are.
http://papers.ssrn.com/sol3/papers.cfm? ... id=1687272
The authors state that from 1871 to 2009, the geometric annual return of US stocks was 8.83%. The call money rate, a benchmark for margin loan rates, was 4.71%. For purposes of comparison, the numbers for government bonds and inflation were 4.68% and 2.08% respectively.
They then looked at the implied interest rate from 1996 to 2009 of 1 year S&P calls with a leverage ratio of 2 to 1. The average implied interest rate was 4.64%; this was 0.26% above the call money rate and 1.89% above the 1 year treasury note rate.
If you go from 2:1 leverage to 3:1 leverage, the marginal interest rate associated with incremental borrowing is 8.01%, considerably more than 4.64%.
The authors concluded that it was unlikely to be cost effective to invest at a leverage ratio of more than 2:1.
Let's assume that this data applies to Canada. I have been unable to find any in the money call options on Canadian stock indices with less than a 4:1 (5:1?) leverage ratio. So I'm not sure that it's a good idea to use in the money call options to obtain leverage in Canada.
You can find deep in the money call options on US indices with leverage ratios of 2:1. Such deep in the money call options have comparatively little time value. An investment in American style options with little time value can be problematic. The solution is to invest in European style options, although they tend to be few in number.
Does anyone know where I can get a list of European style options?
In the same paper, the authors found that the implicit interest rate for S&P500 futures from 2000-2008 was 4.56%. This was 1.29% above the average 1 month LIBOR rate and 0.40% below the call money rate.
So futures offer an interest rate which makes leverage feasible. But they aren't that tax efficient, as the interest isn't tax deductible and there is minimal ability to defer capital gains tax. And futures can't be used in tax advantaged accounts.
My conclusion is that the interest rate at which you borrow money is critical for leverage to be successful.