Leveraged investing

Asset allocation, risk, diversification and rebalancing. Pros/cons of hiring a financial advisor. Seeking advice on your portfolio?
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Norbert Schlenker
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Leveraged investing

Post by Norbert Schlenker »

From the most recent (and perhaps last ever for me) issue of Investment Executive. In an article about borrowing to invest, with an example given of borrowing $50k to match a saved $50k ...
Jade Hemeon, quoting Talbot Stevens wrote:... devised the following questionnaire for clients considering leveraged investing. He calls it "the emotional acid test":

If my leveraged investments drop by 30% in value three weeks from now, I will:

A - want to buy more, because investments now are "on sale";
B - have faith and hold, committed to the long-term plan;
C - hold somewhat nervously, questioning why I leveraged;
D - want to sell, unable to sleep at night;
E - insist on selling, stressed and upset with my advisor;
F - shoot (or sue) my advisor, who introduced leverage.
Stevens goes on to say he wouldn't recommend leverage to anyone in categories D-F and probably not to C either.

I would add that it's not just the emotions of the investor at issue here. The emotions of the lender could also come into play. So I think there needs to be a ...
G - screen my calls to avoid speaking to my creditors
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Re: Leveraged investing

Post by DanH »

Norbert, for what it's worth IE publishes a variety of stuff - including this anti leverage piece by yours truly. ;)

I didn't read that article but have seen and read lots of Talbot Stevens' stuff over the years. I don't agree with a lot of it but at least he can help to moderate the "leverage kings/queens" of the industry (many of which seem to reside in/around my home town). As I read your post two thoughts sprung to mind.

First is that any strategy (or product) recommended to a client should have a clear link to how the recommendation furthers the client toward his/her stated goal - AND how the client is unlikely to achieve the goal in the absence of such a strategy/product.

Second, the test that Talbot should add is whether people would borrow to invest AFTER markets fall by 40% or more. That's when it's smart to leverage so long as the client has ample cash flow to fund the investment. In practice, most advisors using leverage don't start by dipping their clients' toes into the market. They go full tilt and usually have no more dry powder by the time the market crashes. All they can do is hold on and it's a common example of how this strategy - if it's going to be used at all - should be done. At least in my view.
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Re: Leveraged investing

Post by scomac »

It's easier to sell the concept of leveraged investing when times are good then it is when times are bad which is precisely the worst possible time to take something like that on.
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Re: Leveraged investing

Post by parvus »

I actually don't agree with anything from Talbott Stevens. When I was in publishing, he had his own form of leverage. His secretary would offer a free article on leveraged investing, in the hope that I would pay for subsequent ones.

Sorry, I'm a cheapskate. Also a gatekeeper.

I felt about him much the same as I feel about "advisor coaches" who also offered me free articles. It's all sales training -- and "branding" for the profferors of such services.

Many of them are not registrants. Indeed, their advice to successful advisors is to deregister; let your staff be the registrants. Yeah right.

There are roughly 50,000 people in Canada licenced to sell some form of investment product -- mostly insurance and mutual funds. There are roughly 10,000 who have full-blown securities licences.

My best estimate, given that I'm not licenced for anything, is that perhaps 1,000 to 2,000 advisors actually know what they are doing and understand market cycles, risk premiums and so on.

The rest rely on their coaches and the marketing staff of the mutual fund companies and the life insurers. Many of the marketing staff are very, very good (hey, I was there for a time!).

Many, however, appeal to Pavlovian instincts: minimize your taxes. Borrow to invest. Take out a UL policy.

This, I think, is a legacy of the old captive agent insurance marketplace, where liability fell on the company, not the agent. The agent simply sold. One more reason to introduce fiduciary obligations into securities law.

As for the securities side, I do take a look at some IPOs. A new O'Leary income fund is of no interest. On the other hand, if Macquarie is offering an infrastructure fund, I might be interested. But how many advisors know the difference? Their compensation depends in part on selling new issues.

This is not a slam against all advisors. More a slam against the way the industry markets itself. Every advisor aspires to be a high-net-worth advisor. Ain't going to happen. There are perhaps 200,000 families with more than $1 million in investable assets in Canada. There are 50,000 advisors chasing them. Probably 500 -- or fewer --advisors own that business.

Meanwhile, there is a vast, relatively unadvised market of
20 million plus taxpayers. They need help. But for an advisor to be successful in that market, they would need 300 clients each with $100,000 in assets to get revenues of say $200,000 to $300,000 (assuming a 1% advisor fee), out of which staff and expenses and dealer fees have to be paid. In any case, not a lot of time for individualized service, nor tailored stock selection. They certainly don't need advice on leverage; more likely, they need advice on debt management. But they can't afford to pay for the advice, unless it's tied to a product sale.

Leverage might double the AUM. but not wisely.

Sigh.
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Re: Leveraged investing

Post by Thorn »

Two observations on borrowing to invest:
(1) In many cases the funds come as a demand loan, with the potential for an unwelcome phone call in a down market, possible wiping out the loan capital and some of your savings.
(2) For the new investor this is sold as a "way to make more money", i.e. a speculation, since we know that the invetor may
make money or may lose money - neither the salesperson nor the client know the future.
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Re: Leveraged investing

Post by dusty2 »

There is plenty of leveraged investing going on these days and people are making great money. Buy a condo, put down 20%, figure a conservative 5%/year appreciation, ( presently 6.5% in Toronto) wait 5 years for it to be built, a $400,000 condo becomes a $500,000 condo. Only lunatics and idiot housing bubbleheads (presently batting .000) would use leverage to invest in the stock market, although buying the 5 banks might work.
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Re: Leveraged investing

Post by adrian2 »

dusty2 wrote:Buy a condo, put down 20%, figure a conservative 5%/year appreciation
"Conservative" :rofl:
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Re: Leveraged investing

Post by kcowan »

dusty2 wrote:lunatics and idiot housing bubbleheads
Spoken like a real estate promoter :roll:
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Re: Leveraged investing

Post by Park »

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.
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Re: Leveraged investing

Post by LadyGeek »

For new investors, finiki has some background information: Using Margin - finiki, the Canadian financial Wiki

I'd say that the cautions expressed in Usage should be emphasized, perhaps placed at the top of the article in a big bold "Warning! Don't try this at home" statement.
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Re: Leveraged investing

Post by newguy »

Park wrote: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.
You don't have to use all your money, 4:1 leverage with 1/2 your money is 2:1 leverage. Or are you looking for deeper in the money for reasons other than leverage?

Here's the list at M-X, not sure if you've seen this.
http://www.m-x.ca/nego_cotes_en.php?symbol=XIU*
http://www.m-x.ca/nego_cotes_en.php?symbol=SXO*
And there's always EWC
http://ca.finance.yahoo.com/q/op?s=EWC&m=2014-03

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Re: Leveraged investing

Post by Park »

newguy wrote:You don't have to use all your money, 4:1 leverage with 1/2 your money is 2:1 leverage. Or are you looking for deeper in the money for reasons other than leverage?
The reason why I want to go deeper in the money is to pay for minimal time value. The leverage associated with options is more expensive than that of futures. As you know, it's because you're paying for the hedge in an option, and the hedge increases the time value. The above reference I cite would indicate that to get your effective rate of interest down to a level comparable to the call money rate, you have to go deep in the money, where the intrinsic value of the option is about half the value of the security.
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Re: Leveraged investing

Post by parvus »

Why would you go deep in the money -- unless you know something the rest of don't? Deep in the money doesn't sound like hedging. Just curious.
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Re: Leveraged investing

Post by Park »

parvus wrote:Why would you go deep in the money -- unless you know something the rest of don't? Deep in the money doesn't sound like hedging. Just curious.
The goal of going deep in the money is not hedging, but speculation (leverage). I certainly don't know something that the rest of you don't. The assumption of buying a deep in the money call on an index is that the index will increase with time. Although the future is uncertain, that assumption has been true in the past.
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Re: Leveraged investing

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Park wrote:
parvus wrote:Why would you go deep in the money -- unless you know something the rest of don't? Deep in the money doesn't sound like hedging. Just curious.
The goal of going deep in the money is not hedging, but speculation (leverage).
Deeper in the money is less of a hedge and also less leverage.

I just read the paper that links moneyness to interest rates and I think you can just ignore it. They neglect to mention what happens if the market drops. When you buy an ATM call, you participate in the upside and not the downside. They call this a higher interest rate, I call it a hedge, which is worth paying for.

Some things are known when buying an option, the strike, interest rate, and expiration (forget early exercise). The only way your interest rate could be said to change is from paying the spread, ie. you have to pay a little bit more.

You say time value is less for deeper ITM but time value is just the probability that something will happen in the given time. Obviously the probability of having a deep ITM option expiring worthless is lower than an ATM option. However you have to add the 2 scenarios together. ie. You buy and ATM option and pay a bit more but 60% of the time the market goes up and you make a bit less but 40% of the time the market goes down and you lose less.

In actuality the deeper ITM and the longer the time till expiration, the more you pay in terms of implied volatility using the standard BS model. The reason is that extreme events are slightly more likely than implied by a normal distribution, which BS is based on. Therefore it's more likely a deep ITM option will expire worthless than we would 'normal'y assume. The same is true of a long expiration. So if you buy an option 2 years out and sell it one month from expiration you will lose a bit from the change in IV.

This doesn't mean you're getting ripped off just because the model's imperfect, you basically pay what an option is worth given current knowledge. The only real extra cost is from the spread and commissions. That's what you should base your strategy on.

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Re: Leveraged investing

Post by parvus »

Okay, thanks. Maybe I missed something. I thought for hedging, you would want OTM options.
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Re: Leveraged investing

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parvus wrote:Okay, thanks. Maybe I missed something. I thought for hedging, you would want OTM options.
Say you're long a $10 stock and you buy an OTM put with a 5$ strike. You have a hedge or insurance against a drop. It's the same thing as just buying a 5$ strike (ITM) call, but not the stock.

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Re: Leveraged investing

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newguy wrote:
parvus wrote:Okay, thanks. Maybe I missed something. I thought for hedging, you would want OTM options.
Say you're long a $10 stock and you buy an OTM put with a 5$ strike. You have a hedge or insurance against a drop. It's the same thing as just buying a 5$ strike (ITM) call, but not the stock.
IOW, the put-call parity theorem:
S + P = B + C
stock + put = bond + call
(mnemonic: Standard & Poor's = British Columbia)

Playing with the formula:
S - C = B - P
covered call = cash covered (short) put
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Re: Leveraged investing

Post by Park »

newguy wrote:
Park wrote:
parvus wrote:Why would you go deep in the money -- unless you know something the rest of don't? Deep in the money doesn't sound like hedging. Just curious.
The goal of going deep in the money is not hedging, but speculation (leverage).
Deeper in the money is less of a hedge and also less leverage.

I just read the paper that links moneyness to interest rates and I think you can just ignore it. They neglect to mention what happens if the market drops. When you buy an ATM call, you participate in the upside and not the downside. They call this a higher interest rate, I call it a hedge, which is worth paying for.

Some things are known when buying an option, the strike, interest rate, and expiration (forget early exercise). The only way your interest rate could be said to change is from paying the spread, ie. you have to pay a little bit more.

You say time value is less for deeper ITM but time value is just the probability that something will happen in the given time. Obviously the probability of having a deep ITM option expiring worthless is lower than an ATM option. However you have to add the 2 scenarios together. ie. You buy and ATM option and pay a bit more but 60% of the time the market goes up and you make a bit less but 40% of the time the market goes down and you lose less.

In actuality the deeper ITM and the longer the time till expiration, the more you pay in terms of implied volatility using the standard BS model. The reason is that extreme events are slightly more likely than implied by a normal distribution, which BS is based on. Therefore it's more likely a deep ITM option will expire worthless than we would 'normal'y assume. The same is true of a long expiration. So if you buy an option 2 years out and sell it one month from expiration you will lose a bit from the change in IV.

This doesn't mean you're getting ripped off just because the model's imperfect, you basically pay what an option is worth given current knowledge. The only real extra cost is from the spread and commissions. That's what you should base your strategy on.

newguy
The following data is from options on S&P500 Index Futures ($SPX.X). It's a European style option, which I chose for its simplicity. On October 14/13, the price is $1,700.33. The dividend yield on SPY, the ETF for the S&P500, is 1.99%; I use that to calculate dividends. I ignore commissions. I ignore bid ask spreads, and use a price midway between the bid ask spread. Those assumptions will make the calculated effective interest rates lower than they really are. I ignore the compounding of interest. This will make the calculated effective interest rate on the third example slightly higher than it really is.

The Dec 20/14 call option with an exercise price of $1700 costs $105.65
You've effectively borrowed $1594.68 ($1700 minus $105.65)
When the option is exercised, you will pay $1700. Add that $1700 to $105.65, and you've paid an extra $105.32 for the option, that you wouldn't have paid if you bought SPY.
You also forgo dividends. Five quarters of forgone dividends is $42.30
So to borrow $1594.68 for approximately 14 months, you paid an extra $105.32+$42.30=$147.62. The effective annual interest rate is around 7.93%.

The Dec 20/14 call option with an exercise price of $850 costs $818.70.
When you do the same calculations as in the last paragraph, the effective annual interest rate is around 1.03%.

The Dec 19/15 call option with an exercise price of $1700 costs $148.20.
Repeat the same calculations, and the effective annual interest rate is around 6.66%.

On page 158 of "Enhanced Indexing Strategies' by Tristan Yates, he states that the effective maximum leverage ratio is about 4x to 5x. That corresponds to an exercise price of about 75 to 80% of the market price. IMO, he may be optimistic.
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Re: Leveraged investing

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Park wrote:When the option is exercised
But, it's not 'when', but 'if'. What if the index declines to 1500 in the interim? Simplistically you have lost $200 in the stock, or $100 with the option. However, the ATM option has a delta of 0.5, so you have to buy 2. The 850 option has a delta of 1 so you only buy 1.

Now during the decline you have to take into account something called gamma ( the change in delta / changes in underlying price). The delta of the 850 (deep itm) option is still pretty much 1, ie. it hasn't changed at all. But the delta of the ATM option, which is now OTM, has declined to about 0.25, which means it's price is decreasing even more slowly than the underlying.

At this point you need to buy 2 more options to maintain the same exposure, or more likely, you sell it and move to another strike and time. BTW, if the market went up, you'd have to sell some options to maintain the same exposure. The position delta will have increased. You want to maintain a delta of 1 (or 1 * whatever leverage).

Another factor to consider is vega (change in option price / change in volatility). When stocks drop, volatility rises. The ATM option has a much higher vega than the ITM option so it has proportionally larger effect on the remaining time value. The ITM option is still almost all intrinsic value so it doesn't really change with small changes in volatility.

Here's an hourly chart of the last month using P&L of 1*spy, 2*the 170 call (atm) and the 1*85 call (itm)
spyopts.png
newguy

ps. I know parvus is reading, so I threw in lots of commas :wink:
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Re: Leveraged investing

Post by Park »

As you know much better than me newguy, there are three roles for options:

1)income
2)hedging
3)speculation (leveraging a directional bet)

I spent some time looking at options, and for me, came to the following conclusions.

You can use options to extract income from one's portfolio. Warren Buffett has been successful selling puts, and out of the money put credit spreads looked attractive to me. But I decided that I didn't need more income from my portfolio, at least at this time. And I wasn't convinced that in a taxable account, I would be better off using options for income, as opposed to making my own dividends by selling the required number of shares.

You can use options to hedge. The market goes down at times, so it would be nice to hedge those declines out. But about 75% of the time it goes up, and I'm not good at timing the other 25%. Also, based on the limited time I spent on this, I found that options were expensive hedges; perhaps those with more expertise could correct me on this. My conclusion was that a much cheaper but effective hedge was to have a sufficiently long time horizon, in which case options are superfluous.

Finally, you can use options for speculation. I came to the conclusion that margin loans were a better source of leverage overall, but options have some strong points. For example, rules regarding margin loans can be changed by brokerages and regulatory authorities. My impression is that options are less susceptible to such influences. Also, margin loans are not possible in tax advantaged accounts.

Newguy, your preceding post would suggest that you are using options for both speculation and hedging. That may work for you. However, I am unconvinced that hedging using options would work for me. So I'm looking at options for their leverage potential. In that case, the implied interest rate of an option is important. And to get that interest rate down, I need to go deep in the money and to a lesser extent, use long term options.
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Re: Leveraged investing

Post by parvus »

newguy wrote:ps. I know parvus is reading, so I threw in lots of commas :wink:
I am a bit of a comma-unist. :D
Last edited by parvus on 14 Oct 2013 21:09, edited 1 time in total.
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Re: Leveraged investing

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Park wrote:So I'm looking at options for their leverage potential. In that case, the implied interest rate of an option is important. And to get that interest rate down, I need to go deep in the money and to a lesser extent, use long term options.
I'm just pointing out that the 'implied interest rate' you're talking about doesn't exist. You can't separate the hedge from the option. You're doing the right thing by going deep in the money if you want to remove most of the hedging aspect. It's easier to maintain a consistent delta like that. However, if SPY drops to around $110, then you will only have about 90% of your original exposure. You still need to take these things into account if you're going to use options.

Download an option calculator and look at some payoff graphs for different strategies. You don't make more or less money depending on which option you buy after you take into account all the probabilities. Deeper in the money will have lower commissions since there's less need to adjust, but they will have higher spreads.

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Re: Leveraged investing

Post by LadyGeek »

I'm still catching up on the definitions and acronyms.

- ITM is In The Money
- OTM is Out of The Money
- Deep in the money is explained in the Investopedia video: In The Money

Direct link: In The Money Options, the web page discusses this in terms of leverage. So I assume this is what Park means by speculation (leveraging a directional bet).
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Re: Leveraged investing

Post by newguy »

You can try playing here. Keep your eye on delta and gamma. You can see how they're derivatives of the graph just above them.

http://www.option-price.com/option-portfolio.php

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