# Long call as substitute for geared portfolio



## EIB (8 April 2017)

Hey guys, newbie here. Starting out in my investment journey where I have decent cash flows from my job but not much equity at this stage so looking at gearing to maximise my exposure. Was originally looking at getting an investment property as I can leverage right up but given the market at the moment, just not sure I want to be getting into such a heated space at the moment and it would also be a major time suck in terms of finding the right property and managing it. 

So have been looking into creating a geared portfolio of ETFs where I'll contribute cashflows monthly to build up equity. The problem with margin loans though appear to be the higher interest rates (c.5% fixed in advance or 6-7% variable?) and obviously the risk margin calls so I wouldn't be able to get a high LVR. And obviously the risk of outsized losses if the market goes down but I have a long term strategy so just want to ride out the downturns and also dollar cost average during the downcycles.

This has led me to look into ETOs as a potential way of recreating the same exposure as a geared portfolio. If I buy long expiry index call options (12-18 months) ATM (e.g. XJOCO8) and roll those over whenever they get to expiry, would that essentially give me the same returns as holding a geared portfolio (disregarding the tax effects)? And if I take the whole cost of the options as effectively sunk financing costs it works out to be effectively c.2-3% p.a. so cheaper than any margin loan and I also get the optionality and protected downside? Obviously when I roll over, there might be higher volatility so the cost of the options in the future could be higher but would that be comparable to the risk you'd take with interest rate rises in a normal geared portfolio? Just wondering whether I'm on the right track here. 

Thanks!


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## OmegaTrader (8 April 2017)

Do your own research, This is NOT Advice

  The return would depend on implied volatility+risk free rate+dividends.

If this is perfectly priced then no edge. 

If this is overpriced then that would negatively impact the strategy.

If it is under-priced because of distortions such as tax or retail borrowing/investig rates or underestimate of volatility, then the strategy would be superior.

Is it or isn't it IDK unfortunately. That is where the research and analysis comes in....

*Gearing*

1) will the market continue to go up in the long term, that is the assumption of the long term buy approach
2) More gearing is not always better. After a certain point in time over gearing destroys the portfolio by creating too much volatility.



*Options *
1) Options don't get dividends
2) Option may be treated differently for tax, no imputation, capital gains situation etc
3) During times of high implied volatility options can be expensive and vice versa
4) Options usually priced in at risk free rate+intrinsic value+implied volatility
5) Options have asymmetry, the most that can be lost is the price of the option
6) Every derivative has a counter-party, if the counter-party dies, you die, unlike a share where you own the company and it's assets.


*Transaction costs*
1) Broker cost .1%???
2) Spread from the market maker .2-.5%???, long term eto's sometimes don't have much volume, so the spread can be higher


*My opinion*
Do the analysis
Do the research
Don't fall into the over gearing trap


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## Smurf1976 (8 April 2017)

My personal opinion is that someone new to investing should not be using leverage.

Someone new at anything WILL make mistakes, that's virtually a given, and you're much better off making those mistakes with a small amount of your own money. Losing 20% on $1000 of your own money that you used for your first trade = a loss of $200 + brokerage. That sure beats losing 20% on your own capital of say $10,000 which you leveraged up to $50,000 - that equals a loss of the full $10,000.

Same with anything. I wouldn't recommend that someone learning to drive starts out in the CBD during peak hour and heads straight for the busiest bridge, tunnel or other major road. Learning to control the car on the back streets, empty car parks or on a farm is an awful lot safer. Less likely that something bad will happen and less severe consequences if it does. Once you've got the basics of steering, braking and changing gears sorted, then it's time to get some experience in the city and on highways but that's not the place to start. 

Same concept with trading - start small in my opinion. It's better to miss out on some potential profits now than to incur big losses and always remember that the markets will still be there tomorrow. I can't stress that strongly enough - the ASX and other markets will still be there tomorrow so there's no need to rush. Get it working first using only a portion of your own money, no leverage, and only once you've got something working is it time to think about scaling up first by applying more of your own capital and then through leverage if appropriate.


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## EIB (8 April 2017)

Smurf1976 said:


> My personal opinion is that someone new to investing should not be using leverage.
> 
> Same concept with trading - start small in my opinion. It's better to miss out on some potential profits now than to incur big losses and always remember that the markets will still be there tomorrow. I can't stress that strongly enough - the ASX and other markets will still be there tomorrow so there's no need to rush. Get it working first using only a portion of your own money, no leverage, and only once you've got something working is it time to think about scaling up first by applying more of your own capital and then through leverage if appropriate.




Thanks for the reply Smurf1976! Just to clarify, when I say I'm a newbie starting out, I mean in the sense of looking for a long term investment vehicle to deploy the majority of my cash savings and in terms of utilising options as a strategy. I already have a $25k share portfolio where I've been trading/investing smaller amounts into more speculative individual stocks. 

I do understand the power and risks of leverage. It's one of the reasons I'm looking into options. I mean if I'm going to deploy $60k into say an index ETF (whether that's in straight equity or leveraged), I'm putting $60k at risk and if the market falls 10% I've lost $6k. But if I instead buy a c.$2.5k index call option contract and keep $57.5k in cash/term deposit, I get a similar exposure to the upside but the most I will lose is the $2.5k even if the market tanks. Sure I can put a stop loss in a normal portfolio but I then lose the optionality if the market recovers. And since I'm looking at this as a long term investment, I'd prefer to dollar cost average than try time and trade in/out of the market which is where I have no skill/knowledge in. 

Just trying to understand whether using options can be a viable strategy for someone looking to construct a long term passive diversified portfolio (rather than active short term trading).


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## skyQuake (8 April 2017)

EIB said:


> Thanks for the reply Smurf1976! Just to clarify, when I say I'm a newbie starting out, I mean in the sense of looking for a long term investment vehicle to deploy the majority of my cash savings and in terms of utilising options as a strategy. I already have a $25k share portfolio where I've been trading/investing smaller amounts into more speculative individual stocks.
> 
> I do understand the power and risks of leverage. It's one of the reasons I'm looking into options. I mean if I'm going to deploy $60k into say an index ETF (whether that's in straight equity or leveraged), I'm putting $60k at risk and if the market falls 10% I've lost $6k. But if I instead buy a c.$2.5k index call option contract and keep $57.5k in cash/term deposit, I get a similar exposure to the upside but the most I will lose is the $2.5k even if the market tanks. Sure I can put a stop loss in a normal portfolio but I then lose the optionality if the market recovers. And since I'm looking at this as a long term investment, I'd prefer to dollar cost average than try time and trade in/out of the market which is where I have no skill/knowledge in.
> 
> Just trying to understand whether using options can be a viable strategy for someone looking to construct a long term passive diversified portfolio (rather than active short term trading).




The options aint free... The downside protection comes at a price. ie. If the market goes up 10% you'd have made $6k on your 60k index ETF but if you went options your gains could be only $3k due to time value erosion and commissions...


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## EIB (8 April 2017)

skyQuake said:


> The options aint free... The downside protection comes at a price. ie. If the market goes up 10% you'd have made $6k on your 60k index ETF but if you went options your gains could be only $3k due to time value erosion and commissions...




Understood. If I equate that to basically the cost of financing a $60k portfolio, it seems cheaper than the interest rate on a margin loan and you get the added benefit of protected downside? Or is it only cheap at the moment due to low volatility and it can massively increase when it comes to rolling over the option at expiry?


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## skyQuake (9 April 2017)

Looking at options approx 1 year out:

15-Mar-2018 5850 calls trade at approx 240

So you're paying around 5% in prem. Similar to financing a margin loan.

However you're missing out on a div yield of around 3.8% (5.1% grossed up)

This -5% drag on YoY performance will hurt in the long run


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## Virge666 (9 April 2017)

No, just No.

For a lot of reasons, a couple are above, but there are much more.

if you want more returns, sell calls and puts against your existing positions, you will be miles ahead of your above idea.


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## OmegaTrader (9 April 2017)

Virge666 said:


> No, just No.
> 
> For a lot of reasons, a couple are above, but there are much more.
> 
> if you want more returns, sell calls and puts against your existing positions, you will be miles ahead of your above idea.



He wants to be a passive long term investor not insurance writer.


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## EIB (9 April 2017)

skyQuake said:


> Looking at options approx 1 year out:
> 
> 15-Mar-2018 5850 calls trade at approx 240
> 
> ...




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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## EIB (9 April 2017)

Virge666 said:


> No, just No.
> 
> For a lot of reasons, a couple are above, but there are much more.
> 
> if you want more returns, sell calls and puts against your existing positions, you will be miles ahead of your above idea.




Thanks for the reply Virge666! Would be great if could expand a bit more on the other reasons why this is a bad idea? 

I'm afraid I don't understand enough and definitely don't have the time or risk appetite to be writing options. And also probably not enough starting capital/existing positions to make it worthwhile! 

I thought the original basic use of a call option was to give you similar upside exposure as buying shares (less cost of options) but with protected upside. I mean it's essentially a long position in the shares and a long put to protect on the downside. Curious why people think this might not be a legitimate or smart strategy?


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## OmegaTrader (9 April 2017)

EIB said:


> Thanks for the reply Virge666! Would be great if could expand a bit more on the other reasons why this is a bad idea?
> 
> I'm afraid I don't understand enough and definitely don't have the time or risk appetite to be writing options. And also probably not enough starting capital/existing positions to make it worthwhile!
> 
> I thought the original basic use of a call option was to give you similar upside exposure as buying shares (less cost of options) but with protected upside. I mean it's essentially a long position in the shares and a long put to protect on the downside. Curious why people think this might not be a legitimate or smart strategy?




He writes options but that is a different strategy to long term buy and hold-By using call options as a mechanism to gear.





skyQuake said:


> Looking at options approx 1 year out:
> 
> 15-Mar-2018 5850 calls trade at approx 240
> 
> ...




Dividends should be priced into the option or there would be an arbitrage taken by participants.


AT the end of the day, is it better to use options or margin loan, that is the question. 
The answer is in the analysis.

That depends on the pricing of the option relative to dividends, borrowing rate and implied volatility.

Writing options is a completely different strategy. It is hoping that options are overvalued relative to the underlying variables. Like writing insurance, hope there is no collapse or you die. If volatility spikes the insurer must pay.....

my two cents.


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## minwa (9 April 2017)

A call option is not linear - some direct comparisons made are not ideal. You have upsides and downsides, trying to recreate the same profile is virtually impossible. Gamma often underestimated.

Personally If I am bullish on the market I'd hold calls over shares.



OmegaTrader said:


> 6) Every derivative has a counter-party, if the counter-party dies, you die, unlike a share where you own the company and it's assets.




No *exchange* traded derivative has ever defaulted in a major developed exchange. In the case of exchange failure it is very unlikely you will get your claim on the shares too.


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## OmegaTrader (9 April 2017)

minwa said:


> A call option is not linear - some direct comparisons made are not ideal. You have upsides and downsides, trying to recreate the same profile is virtually impossible. Gamma often underestimated.
> 
> Personally If I am bullish on the market I'd hold calls over shares.
> 
> ...




If the exchange folds and you own the shares in your name, you cannot sell them on he exchange but you still own the company. An exchange is a selling place. I own a company I own it. I own a derivative, underwriter goes bust I die. A derivative is with another party

1987 US crash, gov/ fed reserve help to stop exchange closing
2008 GFC, US gov bailed out banks and other gov around the world did the same. 

Anyone got any money with lehman brothers???

Gov comes in every time, so far..


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## minwa (9 April 2017)

OmegaTrader said:


> If the exchange folds and you own the shares in your name, you cannot sell them on he exchange but you still own the company.




If the exchange folds, do you have the papers claiming your ownership on the shares ? Nop, that is on the exchange so if the exchange goes, your public exchange issued  shares goes.


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## DeepState (9 April 2017)

The return on a portfolio of call options will generally not do as well for you as a portfolio of underlying stocks with the same starting 'exposure' when an option is initiated. This is if the portfolio is not levered and your investment horizon is a long one and you think equity returns will exceed cash in general.

If you are leveraging at interest rates like 6-7% pa, well, things change a bit as the options are priced using interbank rates which are below 2%per annum right now.  So, in some ways, it gives you access to the market with leverage at a much lower rate. 

There are break-evens all over the place depending on what you think the markets might do and what specific option characteristics you might choose: expiration, moneyness...and things like tax.  Importantly, how much do you really care about a dollar P&L at the expiry date 12 months away (and such future rolls)?  It's pretty irrelevant for most people unless there is a specific reason for it, but you pay for it as if it does matter greatly.

---

If you have the cash, keep it simple.  The worst peak to trough returns are like -60% for a highly diversified global portfolio in AUD.  Don't invest any more than you can afford to lose.  If you can't help yourself, don't invest any more than a fall of 60% would equate to that same figure.

If you want a levered equity portfolio, buy a levered ETF.  It can borrow more cheaply than you can.  Your losses are limited to the value of the shares.  Just do that if your investment horizon is a long one.

Apart from trading on short term views for minimal outlay, options can make sense if you somehow really value outcomes as at the expiration dates.  That's very rare.  You pay for that exact specification.  If you don't value it, don't pay for it.


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## OmegaTrader (10 April 2017)

minwa said:


> If the exchange folds, do you have the papers claiming your ownership on the shares ? Nop, that is on the exchange so if the exchange goes, your public exchange issued  shares goes.




*An exchange does not issue shares*. A company issue shares. 

eg woolworths will still be here. I would be on the companies share registrar. Lights would still be one, can still buy bread and milk. etc

An exchange is to sell shares. These can also be transferred privately as well

Some interesting points.
http://money.stackexchange.com/questions/23231/can-a-stock-exchange-company-actually-go-bust


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## minwa (10 April 2017)

OmegaTrader said:


> *An exchange does not issue shares*. A company issue shares.
> 
> eg woolworths will still be here. I would be on the companies share registrar. Lights would still be one, can still buy bread and milk. etc
> 
> ...




Public issued shares. Different to private shares.

If ASX goes down, you really think you can go to BHP office tomorrow and receive your claim ? You'd be dreaming if you think the company itself maintains a database of individual ownership that is updated with thousands of names exchanged everyday.


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## OmegaTrader (10 April 2017)

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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## EIB (10 April 2017)

DeepState said:


> The return on a portfolio of call options will generally not do as well for you as a portfolio of underlying stocks with the same starting 'exposure' when an option is initiated. This is if the portfolio is not levered and your investment horizon is a long one and you think equity returns will exceed cash in general.
> 
> If you are leveraging at interest rates like 6-7% pa, well, things change a bit as the options are priced using interbank rates which are below 2%per annum right now.  So, in some ways, it gives you access to the market with leverage at a much lower rate.
> 
> ...




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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## EIB (10 April 2017)

OmegaTrader said:


> I think this is of topic enough.
> 
> Sorry for my part to the original poster.
> 
> ...




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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## DeepState (10 April 2017)

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.
> 
> ...




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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## EIB (10 April 2017)

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.




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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## skyQuake (10 April 2017)

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?




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)


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## OmegaTrader (11 April 2017)

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!




good luck! 

Analyse well and don't over gear

cheers


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## minwa (11 April 2017)

EIB said:


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




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


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## DeepState (11 April 2017)

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.





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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## EIB (12 April 2017)

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.
> 
> ...




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?


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## DeepState (12 April 2017)

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.


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## Virge666 (12 April 2017)

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.


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