Calling the S&P 500 ...

[MustacheAndaHalf]

Does "derivatives indexing" count as passive if I buy and hold for 3 years?

Although I've been investing in very risky stocks, my plan is to head back toward index funds.  Previously I liked deep in the money calls: their low chance of being a total loss, quick break even, and decent leverage.   On Friday I started buying long-dated S&P 500 call options, and decided to get more aggressive.

I'm still too worried about "at the money calls", which expire worthless if the stock drops at all.  Sometimes a good year is followed by a bad year, and that breakeven situation can be a -100% loss for at the money calls.  But it's very uncommon to have a deep drop for 2 years, and that's what interested me.

There's options 7% below the current price, costing 1/5th the stock price.  So I view that as 14x downside leverage and 5x upside leverage.   Still a bit steep.  The $315 option takes a 15% drop to expire worthless, or 7x downside.  The cost gives it 4x upside.  Since drops over 2 years are uncommon, overall there's more benefit than downside.

While everyone was watching GME, I bought 3 year call options on the S&P 500 with about 4.6x leverage.  I pull ahead of owing an index ETF if the S&P 500 gains +3% in 3 years, so I'm happy with that investment.

I'm ignoring many characteristics of call options in my approach: implied volatility (25%), time value and delta.  Even if I monitored those factors for the length of the call option, I doubt I could act before the market.  I find it easier to treat time value as the cost of buying the option.

[Financial.Velociraptor]

Interesting idea. 

I think this is better done after a market crash than after a long run up where P/B P/E P/S are at historical highs.

My gut says if you buying the longest dated LEAP calls deep in the money, you win more often than you lose.  This is just based on the common sense ideas that markets trend up over long periods of time.  It might be worthwhile to do a study on the SPY price movement from the third Friday of January to the one two years hence, over 50 years.  How many two year periods show a gain? 

Looked at another way: If we expect the long term broad index to rise 8% a year on average, you should win (on average) with Time Value that is less than 4% of your IV.  Agree?  That would suggest going as deep in the  money as possible to minimize time value.

[ChpBstrd]

Are you buying these calls to leverage your equity asset allocation, or to replace it?

E.g.
a) Instead of investing $100k in SPY, I'm going to buy $20k worth of ITM call options and put the remaining $80k somewhere safe, or
b) Instead of investing $100k in SPY, I'm going to buy $100k worth of ITM call options and get 5x upside leverage?

[MustacheAndaHalf]

Financial.Velociraptor - Robert Schiller, who created the cyclically adjusted price earnings (CAPE) index, points to earnings / price (flipped) to say that a 3% yield on stocks is better than a 1% yield on bonds.  I'm not certain either way, but that's where the risk comes in.

I didn't pick deep in the money or at the money options this time - I went slightly below the current price, enough to withstand a small dip but not a big one.  When I looked at pairs of returns from 1972 to 2019 (in portfolio visualizer), I rarely saw two down years in a row.  A wipeout should be rare, but possible.  It was uncommon to see a good year and bad year cancel each other out, which would inflict a leveraged loss on my investment but I'd have some left afterwards.

ChpBstrd - That's a very hard question.  I've only started shifting to S&P 500 call options as I cash in on my Covid predictions.  My risk tolerance is permanently higher now, and I've only started doing this.  I hopefully will wind up somewhere in between the scenarios you outline: some cash, some indexing, and some call options on an index.

[Alternatepriorities]

I have no knowledge to contribute here, but I'm interested in understanding the idea better. I'd like to learn more about leveraging before the next crash/opportunity. I poured every spare dollar we had into the market Mar-May, but I did not leverage because I tend to avoid investments I don't really understand...

[ChpBstrd]

ChpBstrd - That's a very hard question.  I've only started shifting to S&P 500 call options as I cash in on my Covid predictions.  My risk tolerance is permanently higher now, and I've only started doing this.  I hopefully will wind up somewhere in between the scenarios you outline: some cash, some indexing, and some call options on an index.

Maybe split the difference since you have a high risk tolerance. Spend 40k of your 100k on calls to get 2x leverage and put the remaining cash somewhere safe. This is what I'm thinking about doing. Maximum loss at maturity would be 40k and maximum gain would be 2x the performance of SPY minus time value lost on the option.

If you do this as a B&H call investor, I suggest buying a lot of duration (e.g. 2+ years) because the time decay is slower for long durations. This of course raises the cost, so maybe your 2x leverage consumes more than 40% of the portfolio when you go out over 2 years. I also suggest rolling your calls after a year or so to maintain that long duration low theta. Also note that this means your calls will still retain some time value, even if the markets tank and they are OTM a year from now. So your maximum loss in a year is not actually 40k, it's something less than that because you'll still have a year or two of time value. Look at earlier expirations to get a feel of where you'd be in a big 20-40% correction.

E.g. A Feb 18, 2022 SPY call at the 305 strike (20% below current price) is about $89.25. For the December 2023 expiry, it's about $100.

That's a year and ten months of lockstep growth potential for only $10.75, or 2.8% of the underlying's value. This illustrates how time decay gets very slow for the longest duration ITM calls, and why you should always roll your calls to the latest expiration date.

Viewed this way, all SPY has to do is grow faster than your 2.8% annual decay rate and you profit.
A 2.8% decay rate is the price you pay for having downside protection after the market has already fallen 20%.
You could spend half your money on an option strategy that will deliver 2(100%-2.8%)= 194.4% of the performance of the SPY unless SPY approaches -20% at which point returns flatten out.

[MustacheAndaHalf]

For me, the calculations are easier on $300 strikes on SPY ($382.57/share):
2022 Dec, $98.25 .. 3.9x lev .. 16.0% time value (0.71%/mo)
2023 Dec, $103.50 .. 3.7x lev .. 20.2% time value (0.59%/mo)
I'm guessing that $5.25/sh (1.4% of $382.57) is rare - I might have worse choices a year from now.

I'm torn between doing something more optimal (rolling over at the 2 year mark) and making it a "one decision" investment.  For example, the 2023 Dec call starts out 5.5% behind owing the stock.  At 3.7x leverage, a 2% gain in the stock (7.5%) equals the 7.4% gain in the options (3.7x 2%).

Another simpler, less optimal approach might be using 1/5th of the account value to purchase new 3 year strikes annually.  That leaves 40% in cash... 20% with 1 year left, 20% with 2 years left, and 20% with the full 3 years remaining.  Talk about a non-traditional 60/40 portfolio!

[Financial.Velociraptor]

@MustacheAndaHalf

Your strategy, if at or near the money has a lot of time value drag.  Going to the deepest in the money strike available decreases your time value as a percentage of total premium.  You lose some leverage but you don't get killed by a long period of consolidation e.g. a "sideways" market.  I think you got good advice to use the leverage to put some allocation someplace "safe".  For "safe" I like closed end municipal bond funds.  I've had good results with IQI and NEA, earning well above inflation fed tax free.  Both of these held up better than their peers in the Feb-Apr covid crash without experiencing a distribution cut.

[ChpBstrd]

I think this is better done after a market crash than after a long run up where P/B P/E P/S are at historical highs.

What sucks about calls is that during a market crash, their time value goes up because implied vol goes through the roof. So if you load up on long calls as everyone is panicking, you'll pay a pretty penny and are set up to lose tons of value if the market fails to rise and IV drops.

For the past decade at least, the rapid recoveries after corrections have made this less of an issue, but there's no guarantee that pattern will continue. Also, the leverage one gets with long calls is very low when the IV is so high.

This pattern works in reverse when hedging. A protective put can be bought cheaply during cheery times when its IV is low, and then sold for a higher amount in a crisis when IV is high (the put's appreciation is not just due to delta). A Calls & Cash strategy like we're discussing enjoys a similar benefit; In the event of a crash/panic, the IV of the long calls will go very high and make the calls more expensive. Someone playing this strategy will have a smoother return function than someone who is 100% stock because rising IV buffers the loss from price change. It would be advantageous to shift from Calls & Cash to 100% stock during a crisis because one would get to sell the inflated IV portion of the option price and keep the same risk exposure. This is another reason to prefer long durations. Vega, the sensitivity of an option to implied volatility, is higher at long durations.

https://www.cmegroup.com/education/courses/option-greeks/options-vega-the-greeks.html

[celerystalks]

How is significantly different from marketimer’s Mortgage Your Retirement strategy at Bogleheads?

[ChpBstrd]

How is significantly different from marketimer’s Mortgage Your Retirement strategy at Bogleheads?

Marketimer used margin loans to buy shares. Maximum loss: > 100% tomorrow.
This strategy involves using some but not all of one's cash to buy call options. Maximum loss: maybe 40-50% across a couple of years?

[celerystalks]

How is significantly different from marketimer’s Mortgage Your Retirement strategy at Bogleheads?

Marketimer used margin loans to buy shares. Maximum loss: > 100% tomorrow.
This strategy involves using some but not all of one's cash to buy call options. Maximum loss: maybe 40-50% across a couple of years?

Gotcha

[hodedofome]

Why not just do 2x-3x leveraged index ETFs for stocks and bonds, rebalanced quarterly or annually.

Or use futures for the leverage and put the free cash in treasury bills.

[MustacheAndaHalf]

Financial.Velociraptor - Alright, sounds like I need to adjust my risk level downwards for S&P 500 call options.  As to closed end funds, I want liquidity.  I've owned micro-cap stocks with wide bid-ask spreads and no market maker, and it's frustrating.  I don't think closed end funds are for me.

ChpBstrd - I think I've seen that in action.  On a short PUT I hold, the underlying stock moved up, making it cheaper for me to "buy to close" the PUT.  But when the stock rose $2, the PUT got roughly $1 cheaper - about half went to time value.   So I've seen the effect for rising prices against a PUT, and can imagine it happens on falling prices with call options.

When should I look for PUT options being cheap?  Do I have to watch the VIX, and buy when it's low?  I've generally found PUT options to be too expensive.

hodedofome - Last year I opened an account at IBKR for that reason.  Vanguard doesn't allow purchases of leveraged ETFs like UPRO (S&P 500 3x ETF).
"On January 22, 2019, Vanguard stopped accepting purchases in leveraged or inverse mutual funds, ETFs (exchange-traded funds), or ETNs"
https://investor.vanguard.com/investing/leveraged-inverse-etf-etn

The choice of leveraged ETFs is limited - you could buy 3x the Nasdaq 100 or semiconductors, but not cloud computing.  So there might still be a place for things like WCLD call options... but those only go out 8 months.

[ChpBstrd]

When should I look for PUT options being cheap?  Do I have to watch the VIX, and buy when it's low?  I've generally found PUT options to be too expensive.

Yes, the VIX is a good proxy for the amount of IV baked into S&P options. Unfortunately, the VIX has been high for almost a year. Last year at this time was the right time to buy puts, as demonstrated by both the VIX and hindsight! It might also be worth watching the term structure for VIX futures, because these will presumably affect the options. There is a bit of voodoo involved in translating the term structure into a narrative and then an investment plan. See: http://vixcentral.com

Overall this is one of my biggest hesitations. Say it's August and we're all celebrating the vanquishing of COVID, the VIX is down to 15, and the stock market is flat. Did the call options I bought in January just get wiped out due to the collapse in vol?

Why not just do 2x-3x leveraged index ETFs for stocks and bonds, rebalanced quarterly or annually.

Or use futures for the leverage and put the free cash in treasury bills.

ETFs that obtain 2-3x leverage often suffer from the loss of value due to contango. Each day, they sell an instrument with little time remaining and buy an instrument with more time remaining and usually take a small loss (see contango/backwardization). Look at the 1 year chart for SPXL for confirmation - it failed to return even 1x across the last 12 months. Thus, although they are buying 2-3x exposure, their actual results are usually something worse than 2-3x, and that goes for the downside too.

With this option strategy, we're looking at 2-3% time decay per year, which I estimate to be better than the typical performance gap for leveraged ETFs, but I might be wrong on that. The compounding nature of SPXL seems to often overwhelm this underperformance factor in rising markets, but I suspect it hurts during falling markets like 2020.

Futures will get you leverage, but they also have a near-infinite downside because they are an obligation to trade, not an option to trade. The appeal of the Calls & Cash strategy is that one can only lose *some of* the value of the calls no matter how bad a crash occurs, and then can lose no more. With futures or leveraged ETFs using futures, one is potentially riding the market all the way down. If dealing directly in futures, one faces margin requirements, margin calls, etc.

Something else I forgot to mention about the Cash & Calls strategy for US taxpayers. If one's calls have lost value and one is ready to roll them to the next year, one could sell the calls on day 356 instead of at a later time to get a short-term loss to offset ordinary income. If the calls gained value, one might want to make the trade on day 357 or later if the 15% long-term capital gains rate is lower than their tax bracket. I suppose one could do something similar with leveraged ETFs. This is not a big deal for me, but may affect some of you high-rollers.

[MustacheAndaHalf]

I think the time value is more serious than I expected, but at least today is a good day to buy.  In case it helps you, the VIX fell multiple days in a row, and is at a local minimum.
https://finance.yahoo.com/quote/%5EVIX/

In another thread, I argued that 3x ETFs follow a different path than the ETF they track.  Regular ETF experiences -20% and then +25%, it's even: 4/5 x 5/4 = 1.  But leveraged ETFs take -60% then +75%, or 0.4 x 1.75 = 0.7.  Another poster said 2x/3x ETFs take out loans/financing when that happens, so they leverage a larger amount on the way back up, which allows them to pay off the loan.

Could 2x/3x ETFs use financing to get over a period of high volatility, and higher "time value" costs?  I agree the evidence shows they don't - they trail their 2x/3x multiple in volatile markets.

2020 performance is now available at Yahoo Finance.
UPRO +10.08% (3x leverage)   ....   XOP -36.45% (1x leverage)
SPDR +18.40% (1x leverage)   ....   GUSH -97.39% (3x losses, then 2x recovery)

Another downside of leveraged ETFs - volatility can make them change their leverage, or even go out of business.  So with GUSH, someone would have taken 3x the losses, then watched GUSH switch to 2x leverage after the crash.  Not a good way to recover from losses!  Call options lock in their leverage.

[MustacheAndaHalf]

When I decide to buy call options, I want to know under what conditions it will be better than owning stock.  Unfortunately, when I first tried those calculations I made a significant mistake by leaving out the break even point.

Call options have "time value", which goes away at expiration.  So I want to see the stock go up by this time value percentage, so it breaks even.  That happens without leverage.  The call option reaches break even with a 0% gain, while the stock has already raced ahead.  Now the call option catches up, with leverage.

Let's say the call options break even after a 10% gain, and are 1/5th the cost of buying stock - they have 5x leverage.  So the stock needs to gain 10%, and then leverage needs to catch up.  At 5x leverage, a 2% stock gain is a (5x2%) 10% option gain... a gap of 8%, which isn't enough.  With a 2.5% stock gain, that's a (5x2.5) 12.5% gain, which makes up for the 10% the stock got ahead.

So stock gains 10%, call options reach break even.  Stock gains 2.5% from there, for a total of 12.5%, and the call options go up 2.5% x 5% = 12.5% as well.  The call options are worth it with +13% of gains, and not worth it before that.  Note this ignores time value.  In actual practice, time value fades slowly, and so any gains in the stock price immediately translate to a higher value for the option.

---
Back to time value for a moment, I have an ideal example of it.  In December I sold a PUT option at $35 on stock that was worth $27 at the time.  I wanted my maximum loss to be -200%, so I picked a situation where I was paid half the stock's price, about $17.50.  My prediction was correct, and the stock gained $10, leaving it at $37/sh.  That's $2 above my PUT option's strike price, so if this holds up, it's worthless at expiration.  What happened to the PUT option?  The time value went up by 1.6x!  The stock gained +37%, and the PUT option only dropped 20% in value/price.  Looks like I'll be waiting out the time decay on that one...

[ChpBstrd]

I keep ruminating on the choice of using a futures-levered ETF versus a Calls and Cash strategy.

-Levered ETFs like TQQQ or SPXL are based on daily moves, but the C&C strategy plays out over a span of years.
-3x Levered ETFs can drop 3x too, whereas the C&C strategy has a floor. SPXL went from $70 to $21 in March. That would be stressful to watch.
-3x levered ETFs are about 3x as volatile as the market, but implied volatility serves as a shock absorber for the C&C strategy (a correction increases IV and salvages some of the value of calls).
-One can sell covered calls against one’s levered ETF and get fat premiums. For example, ATM calls on SPXL maturing in 39 days sell for 7% of the strike price. If one was to YOLO their portfolio on these ETFs, and got to within a few percent of their FIRE number, they could win with a proverbial field goal and prepare to reallocate by selling the call.
-One might collect a similar bonus getting into the levered ETF position, but selling these puts comes at extreme risk.
-The C&C strategy suffers time decay of, let’s conservatively say, 3% of the option price per year. So if we target 2X exposure and the calls cost 25% of the underlying, this decay would cost the portfolio 2 * .25 * .03 = 1.5% per year. The 3X ETF strategy involves paying an expense ratio of 1% per year and suffering an indeterminate loss due to contango. Again targeting 2x exposure we would be 33% cash, 66% 3X ETF. Our portfolio would thus pay .66 * .01 = 0.66% in fees, plus contango losses. A 2009 paper by Lei Lu, Jun Wang, and Ge Zhang found the 2x levered ETFs performed about as expected for 1-3 month holding periods but “over the holding period of one quarter, the relation between the ... ETF and the benchmark breaks down.” They also found that “no matter which direction the benchmark index moves, it is not optimal for index investors to hold leveraged ETFs over long term.” However, I could not interpret the results for something like an annual decay factor.

[MustacheAndaHalf]

I've been thinking about turning what I did in March 2020 into a strategy.  I imagine it could involve call options or leveraged ETFs - but it starts out with a standard index fund and bonds portfolio. 

When the market drops by a significant percentage, I push that percentage into a leveraged ETF.  So after a 20% drop, I push 20% of my remaining portfolio into a 3x leveraged S&P 500 ETF.  If I'm too early, another 20% drop means I push 20% more into that leveraged ETF.

I haven't heard of a leveraged S&P 500 ETF going under.  Oil ETFs had unique conditions in March 2020 that don't apply to the S&P 500.  But maybe that's a reason to favor call options - but those will be much more expensive after a crash, since volatility will be high.

As to which S&P 500 ETF to use, it looks like ProShares UltraPro S&P 500 offers 3x leverage for a 0.93% expense ratio.  Maybe that's better than Direxion 3x S&P 500 with a 1.01% expense ratio?

[ChpBstrd]

I've been thinking about turning what I did in March 2020 into a strategy.  I imagine it could involve call options or leveraged ETFs - but it starts out with a standard index fund and bonds portfolio. 

When the market drops by a significant percentage, I push that percentage into a leveraged ETF.  So after a 20% drop, I push 20% of my remaining portfolio into a 3x leveraged S&P 500 ETF.  If I'm too early, another 20% drop means I push 20% more into that leveraged ETF.

I haven't heard of a leveraged S&P 500 ETF going under.  Oil ETFs had unique conditions in March 2020 that don't apply to the S&P 500.  But maybe that's a reason to favor call options - but those will be much more expensive after a crash, since volatility will be high.

As to which S&P 500 ETF to use, it looks like ProShares UltraPro S&P 500 offers 3x leverage for a 0.93% expense ratio.  Maybe that's better than Direxion 3x S&P 500 with a 1.01% expense ratio?

This sounds a lot like what I was doing with collars and having a plan to drop the hedge when the market was down X% and go all in. Whereas this was talking about going from low exposure to full exposure, you're talking about going from full to leveraged.

It might work brilliantly. The question I ask myself though, is would I be considering this sort of thing if the market had been flat since April, instead of up 75%?

[MustacheAndaHalf]

When the market drops by a significant percentage, I push that percentage into a leveraged ETF.  So after a 20% drop, I push 20% of my remaining portfolio into a 3x leveraged S&P 500 ETF.  If I'm too early, another 20% drop means I push 20% more into that leveraged ETF.

The question I ask myself though, is would I be considering this sort of thing if the market had been flat since April, instead of up 75%?

The start of the recovery was quite fast, gaining +13% between March 23 and April 1st.  As panic subsided, the recovery began.  I think most corrections involve a panic, which might offer the best time to buy.

For my strategy, the dot-com crash is a good test scenario.  What I actually did in March 2020, is buy the stocks that were most likely to go bankrupt.  Trying that back in the dot-com crash would lead to disaster - most dot-com stocks really did go bankrupt, and buying Apple and Amazon for cheap prices weren't enough to make up for it.  So a direct comparison with what I did in March 2020 is very risky in a dot-com scenario.

But running the leveraged S&P 500 through the dot-com crash, there were 3 years where the S&P 500 lost money every year (it made it up in volume!  Sorry, old Amazon joke).  Is a -10% drop significant, like in 2000?  If it is, a 3x leveraged investment at that point would be followed by 72% in losses... but more investment would occur in 2001 (-10%) and 2002 (-20%).

A recovery from the dot-com drops occurred in April 2006, according to Portfolio Visualizer.  Someone who got greedy would learn why that was a bad idea 2 years later, in the Great Financial Crash.

Would most investors wait 3 years at a loss in leveraged ETFs?
Would investors sell off the leverage immediately after a recovery?
Probably not, to both questions.

[ChpBstrd]

Would most investors wait 3 years at a loss in leveraged ETFs?
Would investors sell off the leverage immediately after a recovery?
Probably not, to both questions.

Good point. There is a saying about no plan surviving first contact with the enemy. Similarly, there are algorithms hidden in our own future behavior that we cannot necessarily know ahead of time. Leveraged bullishness seems like a great idea in hindsight, but we don’t have a chart to view future returns, so we’ll lack confidence once we get into the position.

In the event of a correction or bear market, our reference point for the decision to stick with leverage or get out while we can might shift. Instead of anchoring our thoughts on 2009-2020 or 1982-1999, we’d start thinking about 2000-2003, or 1973-74, or 1929-32. We would ask ourselves how many years it will take to recover our retirement from a 70% or 90% leveraged loss. We would ruminate about the mistake in terms of “got greedy” or “was foolish” or “performance chasing”. Then we’d resolve to never play with leverage again and de-lever - near the bottom. We’ll have good reasons then too!

One reason to like Calls & Cash at maybe 1x or 1.5x leverage, or collared positions, is that it will hopefully feel like we did a reasonable thing whether the market goes up or down in the future. If up, we’ll be glad we participated instead of hiding in cash or bonds. If down, we’ll feel smart for putting a floor under our returns and leaving plenty of dry powder for the recovery. The victory might put us in a bullish mood at just the right time.