Long call as substitute for geared portfolio

[EIB]

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!

 

[OmegaTrader]

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

 

[Smurf1976]

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.

 

[EIB]

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).

 

[skyQuake]

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...

 

[EIB]

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?

 

[skyQuake]

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

 

[Virge666]

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.

 

[OmegaTrader]

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.

 

[EIB]

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

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?

 

[EIB]

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?

 

[OmegaTrader]

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.

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

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.

 

[minwa]

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.

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.

 

[OmegaTrader]

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.



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.

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..

 

[minwa]

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.

 

[DeepState]

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.

 

[OmegaTrader]

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

 

[minwa]

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

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.

 

[OmegaTrader]

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

 

[EIB]

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.

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?