2/3/4.../n X Leveraged Strategy : Weapons of Wealth Destruction or Creation - Attempt at DIY Primer
Greetings for 2009 fools!
I have stayed away from blogging myself –although I am very active in responding on others and also having ongoing discussions in the Stinkyfeet board. Also I keep pestering the fool often with discrepancies as and when I come across them at the fool. Eg:
(1) Cost basis adjustments and score adjustments for Rydex Inverse ETF distributions: By my reckoning the distribution ( akin to a dividend) formula used by the fool in these cases was incorrect
(2) DVGL.OB, JADA.OB Price allocation: The fool did not receive price quotes on a lot of Bulletin and Pink Sheet stocks – and thus a lot of us didn’t receive the correct price. JADA.OB had sub 1.50 close on Thursday – would have allowed a lot of us to get out .
(3) NCTY: A lot of fools are showing 400+ points garnered on this pick in 2008 with a $100+ quoted price – which don’t show up anywhere else.
Anyway I digress. The point of the Leveraged ETFs are increasingly becoming important as their popularity increases – both here in the Fool and outside I am sure. The issue has definitely become magnified with the introduction of the Direxion 3x ETFs.
I am surely missing a few but here’s a good compilation of comments on the fool:
(1) Tasty’s excellent and if I am not mistaken the first post on this subject in the Fool : HERE
(2) Kcanant’s post on DXO ( This is the 2x Leveraged ETN on oil):
(3) My Bear pitch on DXO and my rationale: HERE
(4) David’s recent post on the Leveraged ETFs ( which really triggered this post and hotrods1431 query on ERX ( although he said ERZ) ) : HERE
No Denying the Danger
I have actually used the phrase “Weapons of Wealth Destruction” against these ETFs. A lot of fools have realized their peril ( included: GMX – who is a timer and plays it well but acknowledges the problem in my DXO bear pitch, FB – who has redthumbed ALL simultaneously, incidentally here was a nice idea from ReaganD on this very topic : Dex …I think the list goes on)
Abit in the latest post by David quoted above says: “These leveraged ETFs should be considered as derivatives and are dangerous like derivatives”. There’s a small correction : THEY ARE DERIVATIVES , hence are AS DANGEROUS as derivatives. Ie for commonfolk that means Options.
And of course with Options: you risk only capital where you are ready to loose 100% ALL THE TIME. This is of course true of a lot of stocks in this meltdown .
Basics of Leverage
I think most of the people know what this is : the simplest example is the Home Loan Mortgage: You typically have 10% down payment – the bank lends you 90% and you own the house – well that is a 10: 1 leveraged transaction (10x) – you gain/loose 10 times of each 1% movement of the house.
Lets turn it around and look at it from an investor standpoint. Lets say what would be an easy run-of-the-mill way for an investor who owns his house “clean & clear” and wants to invest/speculate in real estate – and lets say the bank A. agrees to loan 100% of the value of his house – he can then easily buy “clean & clear” a house similar to his own and thus create a 2x leverage or of course he can go to 10 banks and do a 10% downpayment on 10 similar houses and thus be borrowed and doomed to the hilt. ( You say cant’ happen in real life – well you know what I say!)
Well that’s how it works in real-estate and in most physical markets , the issue of course is – by buying the 10 houses – the investor is bound to increase demand/supply imbalance and has to pay a little more with each transaction. This is really what stops Fundhouses from playing this the old way . If you had a 2x Exxon ETF : They can easily try borrow against your money and buy 2 shares for every 1 share of XOM you funded - but that would move XOM big time. Also there’s the problem of not many people will lend 100% against a XOM share. Additionally, these Leveraged ETFs are based on indexes , making this impossible to execute on all underlying scrips of the index.
So in comes Index futures,swaps,cash, treasuries. Basically using a blend of these 4 instruments ( 2 of which are Derivatives) you can create almost all “n”x leverages within rational bounds! And the great thing is notionally they do not move the underlying – but of course demand/supply has to affect something - and in this case , it’s a nice little thing called “Volatility Premium” which drives the price of the derivative itself. But there’s so much beauty ( ahh! Hmm! Cough! Splutter!) in these – since most of them are priced under sophisticated variants of the Black-Scholes model , the “Implied Volatility” which is what is actually used to price – can’t really diverge too much from the “Actual Volatility” displayed by the stock.
Thus for eg on GS Pitch by: d1david 10/31/08 3:54 PM
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they just opened front month puts in the teens... sounds like Bear Stearns
The people who did that profited huge from something like this (10-20x) – because GS was still at $90+ and although “actual volatility” had climbed – it never would have priced in an “implied volatility” of seeing GS at $48 on Nov 21st. ( There are a lot of subliminal messages here – which I won’t elaborate, but you should understand at least why I follow the people I follow – David had an outstanding call)
DIY : Have I gone mad? – Grandma’s Option Strategy , if it ever can be
All right if you have made it till here, I am actually going to walk thru some examples of how to implement a 2x strategy yourself – which I hope should give you enough insight to make a call on what course of action you want to take:
Derivative/Option Pricing = Underlying Stock/Index price + Implied Volatility Premium + Time Value Premium + other ( very minor, things like dividend yield etc)
Lets go back to the XOM 2x example. It is good because Exxon is an extremely liquid stock as well an option. Lots change hands – Bid/Ask spreads are small (This is extremely critical from a DIY perspective)
As of Friday’s close XOM was at 78.10 with a movement of $1.44 for a % change of 1.88%. In order to implement a 2x ( say Long) strategy: You need to look at Calls expiring nearest month ( which is Feb) and see at which strike do you get a 2x price movement ie called the Option Delta
Delta % = % of option price change/ Stock Price change – looking for a value of 2.
This happened on Friday on the FEB 40 XOM CALL. Let me say that again the 40 call – when XOM is at $78+! People like GMX who are active Option traders are going to laugh their guts out. Volume on this strike was close to non-existent – well this is truly a Grandma’s Option strategy, what chance does XOM have of ending up below $40 in Feb for you to loose 100% on this?
But lets turn this around and ask how did FAZ or SKF ( the 3x and 2x Bears) which were at about $200 and $300 on Nov 20/21 end up at $30 and $100 in Dec/Jan?
The issue is duration – or in some sense buy/sell. See if you buy this XOM call now - You are almost GURANTEED to be assigned in Feb ie you have to fork up the money to buy the underlying stock – so lets say you bought 1 call : Cost of 38.20x100 ( each call =100 shares)=$3820 instead of buying about 50 shares of XOM ( There’s your 2x leverage) . But if that’s all your capital is – you have to sell sometime before expiry to avoid forking up the extra $40x100=$4000 to buy up the actual shares.
Ie Net investment = 3820+ 4000= 7820 for 100 XOM. Whether you make money is dependent on obviously where XOM ends up.
There’s another problem , this 2x or Delta %=2 is valid ONLY on price action as of Friday. With time ie everyday the “Implied Volatility” and of course the price will change and so will the Delta. Thus in order to assure the buyer the constant 2x/3x – the funds have to deploy a DAILY REBALANCE – by trading in and out of these and changing the mix between the derivative, cash and treasuries. Eg Lets take this strategy
The $60 strike has a Delta % =4 so by investing in 1 60 call for $18.40x100=1840, and keeping the rest of
$3820-1840=1980 you could try to mimic the above strategy ( actually not since the price is not exactly half – its cheaper, due to Implied Volatility premium – but its close to 2x, actually 1.93x).
This is not a sedentary strategy anymore – because its somewhat closer to the $78 price – and this Delta% WILL MOVE quickly based on the underlying. So to maintain a constant leverage – you’ll have to move strike prices accordingly.
Liquidity: The highest volume was experienced in the 75,80,85 strikes. Not at the ones I mentioned. Thus for a fund – you know where they have to play.
I hope some of the problems of these ETFs are becoming clearer.
Thus specifically for the inverse Financial ETFs – I am going to use the XLF , a 2x Inverse strategy could involve buying the 14 Feb put which appx has the 2 Delta % and costs $4.50 when XLF was at $9.68 Friday. The Implied Volatility is 95.2 when VIX today is at 46. I distinctly remember some 200 Volatility in the 90 VIX days.
Lets compute the volatility premium on this Put: its basically 4.50- (14-9.68)=.18 and that translates to about 4% ….I am pretty sure on Nov 21st it would have priced around 2.5x
Thus on Nov 21st when XLF was at 9.40 the 14 DEC PUT ( I am guessing) would have cost = (14-9.40 Intrinsic) + 10% premium = $5.00 appx.
On Dec 19th ( expiry) XLF was at 12.2 and VIX was at 44 – which actually would have made the puts around 1.80 ( no time left – so intrinsic only) = LOSS= (5 -1.8)/5=64% which incidentally was the same movement in SKF.
WHEW! THAT WAS LONG!
So ETF ISSUES/ADVANTAGES.
(1) They are almost worthless as a long-term Hedge/Long Investment strategy
(2) They are akin to buying/selling IN-THE-MONEY OPTIONS on a daily basis
(1) They do the Buy/Sell for you
(2) Hence, Great trading tools
So DIY PROS/CONS
(1) You can do it and avoid the daily BUY/SELL.
(2) You can spread out the Expiry by doing what’s called a CALENDAR SPREAD ( Great for a Low-Leverage long term strategy)
(3) Would you have bought XLF Puts on Nov 21st…most likely you bought SKF in Sept when the LEH/AIG Crisis hit….SKF was around 120 then ….lets see what the puts would have done
If you bought the Oct and Dec puts when XLF hit 19 on Sep 16th ….with Volatility still in the 30s the strike would have been 25…that means possibly a price of about $6.20 for Oct and around $6.40 for Dec and held thru and sold on open market on day of expiry:
Transaction 1: Oct Put on Oct 17th with XLF at around $15 = for $10 and
Transaction 2: Dec Put on Dec 19th with XLF at around $12.50 = for 12.50
Thus your return = ( 10+12.50-12.30)/12.30= 83% while XLF movement= -36%. SEE THE POINT ABOUT NON-CONSTANT Leverage. You would have made a little bit over 2x.
When to Buy/Sell: Basically if you have a long term strategy you will need to roll-over ( ie move the expiry by buying farther out) .
LONG TERM STRATEGY for ERX ( Ie Energy Bull)Hotrod
..... Wanted to reply in David’s post but here goes:
Your underlying scrips should be IYE,OIH,USO.The last 2 have Options all the way in the LEAPS.Choose your mix. Use OIH and USO leaps and maybe IYE near-term (3 months) and roll-over everytime on the IYE. Would beat ERX hands down.