# Leverage methods



## james4beach (Nov 15, 2012)

A few methods I know of to achieve leverage are:

(A) broker margin, can get up to 2x exposure and incurs margin loan cost
(B) open a bigger position and fund it yourself, somehow, e.g. reduce fixed income
(C) ETFs like HXU (Canada) and SSO (US), track daily but not long term

I'm trying to make sure I understand the differences between all of these. As I understand it,

(A) gives you perfect tracking as long as the security's margin requirements don't change, but incurs the margin loan expense (4%/yr or whatever). Since you don't want to operate right at edge of margin requirement you can realistically get 1.5x to 2.0x exposure sustainably, I think?

(B) either comes for free, if you simply reduce asset allocation elsewhere to come up with the money, or incurs a loan cost if you borrow on a LOC etc. Security margin requirements don't come into play.

(C) work great for daily tracking of 2x or 3x, but longer term are much worse at tracking. e.g. in 2015, XIC returned -8.4% but HXU returned -19.4%

Does that about cover it, or am I missing other popular methods for leverage?


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## Rusty O'Toole (Feb 1, 2012)

You forgot options. Depending how you want to do it, you can buy an option or put on an option spread for much, much less than buying the underlying with limited risk.

Read an interesting take on stock options the other day. The writer claimed the usual modelling tools like Black-Scholes broke down when considering a binary event. He gave the example of a company whose stock was selling for $60 a share, that got involved in a lawsuit that could ruin the company. The stock dropped to $30.

He figured the stock was either worth $60 (if they won the lawsuit) or $0 (if they lost) but it was not worth $30. The out of the money options, priced on a 'standard deviation' model he figured were way underpriced. After a lot of research he concluded the lawsuit would fail, bought a big pile of out of the money call options, and made a profit of 20X his investment.


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## GoldStone (Mar 6, 2011)

You missed stock warrants.


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## tygrus (Mar 13, 2012)

derivatives baby


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## james4beach (Nov 15, 2012)

Thanks everyone, yes I missed options, warrants, and futures. Massive leverage via futures.

I have often considered the idea of using long dated XIU call options as a way to stay long the TSX. Does anyone follow this methodology? I just don't know how to model such a thing.


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## tkirk62 (Jul 1, 2015)

Another one to consider would be simply choosing a company with a lot of debt of their own. 

This especially works when you look at sector turnarounds. The best example I can think of would be the recent slight rally in energy stocks. The stocks that have gained the most are not the "safe", low debt entities. It has been the debt riddled companies who have bounced the hardest. They dropped further in the downturn and have gained more in the upturn. If you wanted leverage to an oil rally you could have invested in Crescent Point instead of borrowing money to invest in CNQ (for an imperfect example). The same could probably be said for precious metal stocks.

To me this method leads to a greater chance your investment ends up worth 0 (higher chances of company bankruptcy) but lower chances of you yourself being ruined by it (your obligation is limited to the capital you initially invested). The leverage methods I use are more along the lines that you list (I use lines of credit and low interest balance transfer offers on credit cards), but it is another method to consider. You could even combine it with other methods to increase leverage by layering the above methods. You could borrow money to buy options on high debt companies if you were really into that sort of thing.


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## humble_pie (Jun 7, 2009)

james4beach said:


> Thanks everyone, yes I missed options, warrants, and futures. Massive leverage via futures.
> 
> I have often considered the idea of using long dated XIU call options as a way to stay long the TSX. Does anyone follow this methodology? I just don't know how to model such a thing.




re XIU & its LEAPs call options, you'll remember that these were discussed extensively as a necessary component of a DIY equity-linked principal-protected GIC strategy, no?

as for buying them, i do own XIU. I also trade its LEAPs calls from time to time. Right now i've just sold 20 to hold the remaining 10.

as for modelling their purchase, there's actually nothing to model IMHO. When one gets right down to it, there's not much choice. 

- one buys the longest term LEAPs that exist. These are the march calls of 2018.

- one buys a strike that's fairly close to market price. Right now these are the 19s to 21s.

- one looks for calls with maximum open interest. Liquidity will help if one decides to sell.

- right now, there's only one candidate. Please take a look jas4, it'll jump up & wave at you.

- after the selection - one might monitor 2 of them - one settles down & watches IV & the greeks for a favourable buying opportunity.

keep in mind that the large & liquid XIU options market in montreal is dominated by institutional players. They are all as tough as maximum security prison guards. The market maker knows this. Nobody is going to voluntarily give a nickel. Still, it is possible to pay an advantageous price. If you like, i'll send you some hints that work for me, at least now & then.

hint numero uno: keep your expectations modest. Like i say, these players are not going to volunteer a nickel.


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## humble_pie (Jun 7, 2009)

tkirk62 said:


> Another one to consider would be simply choosing a company with a lot of debt of their own.
> 
> This especially works when you look at sector turnarounds. The best example I can think of would be the recent slight rally in energy stocks. The stocks that have gained the most are not the "safe", low debt entities. It has been the debt riddled companies who have bounced the hardest. They dropped further in the downturn and have gained more in the upturn. If you wanted leverage to an oil rally you could have invested in Crescent Point instead of borrowing money to invest in CNQ (for an imperfect example). The same could probably be said for precious metal stocks.
> 
> To me this method leads to a greater chance your investment ends up worth 0 (higher chances of company bankruptcy) but lower chances of you yourself being ruined by it (your obligation is limited to the capital you initially invested). The leverage methods I use are more along the lines that you list (I use lines of credit and low interest balance transfer offers on credit cards), but it is another method to consider. You could even combine it with other methods to increase leverage by layering the above methods. You could borrow money to buy options on high debt companies if you were really into that sort of thing.



eek. Good thinking on a strategy that works for some. Why lines of credit & short-term funds from low interest credit card transfers, though? wouldn't one use broker margin for the best rate?

but still, eeks


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## Eclectic12 (Oct 20, 2010)

There's also split shares where one type participates in the lion's share of the growth while the other type does not participate in growth but usually has downside protection.


Cheers


*PS*

A quick comparison of BNS versus the capital shares of a BNS split corp (BSC), buying BSC required one sixth the capital of buying common BNS stock. In the time BNS share price was a bit under a double, BSC was a bit under a double.


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## tkirk62 (Jul 1, 2015)

humble_pie said:


> eek. Good thinking on a strategy that works for some. Why lines of credit & short-term funds from low interest credit card transfers, though? wouldn't one use broker margin for the best rate?
> 
> but still, eeks


The LOC was a student line of credit with a very good rate and an advantageous repayment schedule. The short term, low interest balance transfers are a way of investing in advance. I know I can save $5000 easily over the course of a year. If I see an investment opportunity now then I can take advantage of the balance transfer, pay down the card over the course of the year. I's just a matter of getting the money in the market longer. I also use my brokerage's margin if I see an opportunity arise but for 1.99% (or better) I don't see how small balance transfers are a situation that prompts an "eeks".


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## humble_pie (Jun 7, 2009)

tkirk62 said:


> Another one to consider would be simply *choosing a company with a lot of debt of their own.*
> 
> This especially works when you look at sector turnarounds. The best example I can think of would be the recent slight rally in energy stocks. The stocks that have gained the most are not the "safe", low debt entities. It has been the debt riddled companies who have bounced the hardest ...
> 
> *To me this method leads to a greater chance your investment ends up worth 0 (higher chances of company bankruptcy) but lower chances of you yourself being ruined by it (your obligation is limited to the capital you initially invested)*




the above in bold are the "eeks."

nothing to do with using a few shekels from a student loan or borrowing a few shekels by running around doing low-fee or no-fee credit card balance transfers.

as you say, it's during the approach to & the trough of market collapses that the high debtors crash the lowest. They look appetizing, especially to novice investors. But the risks of bankruptcy are at their zenith. These companies are very, very, very risky.

when you suggest - ever so casually - that an investor cannot lose more than 100% of his capital, won't you please ask yourself whether our OP is an investor who is willing to lose 100% of his capital.

won't you please consider whether 95% of this forum are investors who are willing to lose 100% of their capital .each:


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## tkirk62 (Jul 1, 2015)

Okay, I see now. My apologies for the misunderstanding.

I of course mean 100% of the capital invested into one investment that is hopefully a small component of a diversified portfolio. I would never suggest anybody invest 100% of their money in PWT. That is very different than suggesting that if somebody believes in oil's recovery they could invest 2-5% of their portfolio in PWT as a leveraged (by way of Penn West's debt) bet on oil. There is a chance to lose that entire 2-5%, not 100% of their entire portfolio's capital.


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## humble_pie (Jun 7, 2009)

^^

the smallness of the component makes all the difference in the world imho. I recently bought shares in a severely stressed, severely depressed company. Not in the oil sector. It has a grand old history, management was in the midst of renewing itself, out with the old CEO & a couple directors, in with the new. Plus this company has decent US options that can be sold.

still, the total holding is only .03% of what i sincerely hope might be described as a diversified portf.


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## doctrine (Sep 30, 2011)

Other sources of money:

-Unsecured lines of credit
-Secured lines of credit (against real estate)
-Investment loans


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## Pluto (Sep 12, 2013)

The best leverage I ever used was a mortgage on a principle residence in a growing city. It by far, out performs most stock portfolios and the capital gain is tax free. Most young people should not even dream of stocks until after they have their house. 
Banks love to loan money for houses, but try to get a bank loan for stocks, forget it....Unless you have a house for collateral. 

Here is what one person I know did. 
1) bought a house with rental unit to pay mortgage. 
2) After 5 years the equity was substantial, so went to the bank to get a second mortgage to purchase stocks. No problem. 
3) 2008 trouble brewing so sold stocks and kept payments up on second mortgage. The October crash came. Bought stocks at low post crash prices with borrowed money. March 2009, second market bottom doubled up on stocks using margin account. The mortgage + the margin account made the leverage phenomenal. 2010 sold enough off get of margin and pay off mortgage. The % gain was tremendous. This is not for those with a heart condition.


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## tygrus (Mar 13, 2012)

The ultimate leverage.

Take your heloc, buy a 3x inverse ETF on margin....and hold on for a wild ride.


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## james4beach (Nov 15, 2012)

humble_pie said:


> re XIU & its LEAPs call options, you'll remember that these were discussed extensively as a necessary component of a DIY equity-linked principal-protected GIC strategy, no?


Right... and I used to do this (rolling my own stock linked GIC) when interest rates were higher and it was easy to earn interest on the cash component to pay for the call option. What a beautiful method!



> as for modelling their purchase, there's actually nothing to model IMHO. When one gets right down to it, there's not much choice.


Well the choice is whether to engage in the trade or not, perhaps to seek alternates like HXU or conventional leverage.

I think the modelling component comes into play due to the time/volatility premium. I think you'd have to model it to figure out what your expected net gain/loss would be in case the underlying moves by X. If you don't model it, how do you know whether it's advantageous or not to use calls for this purpose?


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## humble_pie (Jun 7, 2009)

james4beach said:


> Right... and I used to do this (rolling my own stock linked GIC) when interest rates were higher and it was easy to earn interest on the cash component to pay for the call option. What a beautiful method!


really? then why asking How to do?



james4beach said:


> I have often considered the idea of using long dated XIU call options as a way to stay long the TSX. Does anyone follow this methodology? I just don't know how to model such a thing.






> the choice is whether to engage in the trade or not, perhaps to seek alternates like HXU or conventional leverage


there are qualitative factors that modelling won't prove out. For example some in this thread say leverage first by buying a house. I believe Buffett himself is on record as recommending home ownership before stock ownership.

but qualitatively speaking it wouldn't do a temporary sojourner in the US of A much good to buy a house in portland oregon for a couple of years, because of the high risk that the housing market could go down in such a short time frame. Not to speak of all the legal & real estate commission costs of taking this leverage route short term.

on the other hand the joys of home ownership could conceivably outweigh the risk of loss of tens of thousands of $$. Is there a model that would take issues like these into consideration? 





> I think the modelling component comes into play due to the time/volatility premium. I think you'd have to model it to figure out what your expected net gain/loss would be in case the underlying moves by X. If you don't model it, how do you know whether it's advantageous or not to use calls for this purpose?


XIU options other than DITM have low deltas, don't move all that much. Still, i'm a Kisser. They goes down in a mini-crash, i buys. They goes up, i sells, duh. Tis the best that a poor pie can manage.


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## spongewen (Nov 26, 2015)

Pluto said:


> The best leverage I ever used was a mortgage on a principle residence in a growing city. It by far, out performs most stock portfolios and the capital gain is tax free. Most young people should not even dream of stocks until after they have their house.
> Banks love to loan money for houses, but try to get a bank loan for stocks, forget it....Unless you have a house for collateral.
> 
> Here is what one person I know did.
> ...


Agree, purchase a house -> wait for appreciation -> refinance to unlock bigger equity -> use credit line against home equity to invest in stocks. You can't get the degree of leverage for stocks from banks as the one you get for real state. And most of time, a credit line against your home equity offers the lowest interest rate.


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## james4beach (Nov 15, 2012)

humble_pie said:


> really? then why asking How to do?


For me the "guaranteed stock index GIC" was easy to model. I know how much the call cost, it's premium is known. I know how big a GIC deposit to make such that the interest pays that premium. Now I could make a graph and show the guaranteed total return of the GIC + call together ... given an XIU movement in %, based on intrinsic value, what would my synthetic vehicle be worth at expiration?

Thing is, that picture had an intuitive meaning including the possibility for loss. It showed me how much the index would have to move for me to make a profit, and I found that useful.

With using pure calls I'm not getting an intuitive feeling of the result, which makes it hard for me to figure out whether it's a good deal. Part of the complication comes from the loss side of the outcome. Sure, we can evaluate the upside pretty easily, but how do you factor in the downside in evaluating whether it's a good deal overall?

Here's how I might attempt to do it. humble_pie and others, I'd love your thoughts on this!

Bourse de Montréal (love the default French website!) shows me a slightly OTM March 2018 call, strike $21, for around $1.30. From this I construct a plot of worst-case profit/loss at expiration as a function of move in the underlying XIU. For example, if the index rises 20% to 24.52, the intrinsic value at expiration is 3.52 and the net profit is 3.52/1.30-1 = 171% return.









To do at least as well as straight XIU, you need XIU to rise by about 10% which gives you a net 13% profit. This tells me that this option is NOT a good buy. Reason: the break-even point is too high and even a decent return in XIU (say 5% per yer = 10% total rise) doesn't give you any leverage. Bad deal.

Let's try DITM. March 2018 strike 14 calls can be bought for 6.68. If I construct the same plot, I get:









This looks a lot better to me, going with the March 2018 strike 14 (DITM). To do at least as well as straight XIU, you need just a 2% rise in XIU. Once you get mildly positive, you have leverage. A 5% annual return in XIU, 10% total rise, gives you 27% net profit ... nearly 3x leverage. And these are worst case scenarios using intrinsic value. You will be able to sell the option for more than this!

So that's how I would "model" and reason these, and it leads me to buying deep in the money XIU calls. It's not very straightforward as you have to apply some logic about what's a reasonable move on the XIU. Thoughts?


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## james4beach (Nov 15, 2012)

Here's maybe a more useful chart, showing the net profit on the 2018 call strategy, in annualized terms.









humble_pie, this is what I mean by modelling. For example this deep in the money strike 14 call seems possibly attractive. If you believe XIU will be positive by 2018, it offers you better than 2x leverage. Even a reasonable 4% annualized increase will give you at least 10% annualized profit.

Do you think this call can effectively be used as a way to be "leveraged long XIU", instead of something weird like the Horizons double TSX?


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## james4beach (Nov 15, 2012)

humble_pie any thoughts on this? Am I being way too pessimistic by evaluating the outcomes only at maturity?


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## atrp2biz (Sep 22, 2010)

When one thinks about options, one has to think about probabilities/volatility. Over the long-term, an 80% probability of achieving a 20% rate of return is the same as a 20% probability of achieving an 80% rate of return. A long OTM option would be akin to the latter scenario, while a deep ITM option or the underlying would represent the former.


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## james4beach (Nov 15, 2012)

Interesting, thanks. So the OTM approach is saying... "sure, I acknowledge that this attempt to ride a big advance in XIU is unlikely to succeed, but when it eventually does, I'm going to get a crazy profit (like 6x or 10x)" -- is that about right?

That still seems like a very difficult scenario to calculate and model. This seems like the kind of thing that institutions have a huge advantage over you & me, with their Black-Scholes implementations, accurate stats on market movements, etc. As a retail investor I feel that I'm inevitably at an information disadvantage to evaluate those odds and expected payoff.


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## humble_pie (Jun 7, 2009)

james4beach said:


> humble_pie any thoughts on this [a DITM 14 call of mar/18]? Am I being way too pessimistic by evaluating the outcomes only at maturity?




so sorry i only re-stumbled into this thread just now.

oddly enough, you have modelled yourself into a somewhat unusual option position that happens to be a type i employ frequently, although it is not popular. This is deeply discounted DITM LEAPs. I utilize them as the long leg of diagonal call spreads.

XIU closed yesterday at 20.15, your march/18 14 call was 6.03-6.45. The intrinsic value is 6.15. As you can see, the bid price is less than intrinsic value while the ask price is only 30 pennies above. You yourself have already posted on this low ask price.

for several reasons, it will be difficult-to-impossible to knock much off the ask price, if you are a buyer, although the montreal exchange can nearly always be counted upon to give up a nickel.


*let's conservatively suppose one could have acquired that DITM 14 call of mar/18 yesterday for 6.40.*

what makes such a choice unpopular is that a) it's expensive; b) it ties up a chunk of capital but at most brokers it does not generate any margin even though it's a positive position; & c) there's no open interest to speak of, ie there are no counterparties playing this option.

this last aspect means that, if you wanted to sell this option before maturity, you'd have to deal with the one-eyed market maker.*

bref, it's a cheaper sleeper. As atrpdocbiz says, it's the choice with an 80% probability of success that could return 20%.

*to find decent open interest in the march calls of 2018, one has to go up to the 21s*. But here the premium rises, one would be paying at least $1, all in theoretical value as this is an OTM call. Here we have - again as atrpdocbiz says - a 20% probability of an 80% success.

when i gaze at the full XIU option chain, the high open interest in most of the 21 strike positions catches the eye. Take a look at the september 21 call open interest, jas4! while you're at it, regard also the september 23s!

i rarely look at full XIU option chains, but whenever i do i usually see these giant institutional positions. The positions are probably linked in a strategy somehow, but we of course have no idea how, or whether long or short stock positions are included in some fashion. Keep in mind that the montreal exchange itself has no idea what the linking strategies are either, because the counter positions could be stock on the TSX or in the US, or could also be US options on the same underlying.

i always imagine these submerged institutional block positions in XIU as huge hippopotamuses lazily sleeping underwater in swamps, with only one eye partially open just a crack above the surface ...


*returning now to your XIU 14 calls of mar/18, you *could* sell* the 20 calls of mar/17, if you are hellbent on XIU. These are .92-1.07. They are more liquid than the 14s of 18, so you could likely fetch 1.00 for them. What you would have then is a diagonal call spread with a net cost of 5.40. As you can see, the strategy is capped at a $6 profit (20-14) so it is not that great of a deal. My math shows me a return of 11.11% over 10 months if XIU rises north of $20.

keep in mind that one should not wait around for the march 2017 expiration of the short call. My usual practice is to take diagonals out as soon as they turn reasonably profitable. Very roughly, these days i'm defining reasonably profitable as 10% or better in a year or less.

the reason for taking them out as soon as they turn profitable is that the upside of this kind of call spread is capped. This 14/20 pair will not ever pay much more than $6, so one might as well lose the position once 6 has been reached.


* there is an exception but it requires much fancier modelling. Too much to explain here, you are probably asleep already!


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## james4beach (Nov 15, 2012)

humble_pie said:


> oddly enough, you have modelled yourself into a somewhat unusual option position that happens to be a type i employ frequently, although it is not popular. This is deeply discounted DITM LEAPs. I utilize them as the long leg of diagonal call spreads.


Thanks humble_pie for all these details... I am studying through this, will take me a while to absorb


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## james4beach (Nov 15, 2012)

This is interesting. So you're pointing at the disadvantage of such a *small open interest,* even though the pricing vs intrinsic is wonderful.

So if I'm reading your post right, you're saying it's usually advantageous to shift towards greater open interests (that will have better liquidity and multiple counterparties instead of just one MM)... and also that you'll want to close any of these positions before expiry?

Certainly requires a lot of trading skill and a good feeling (from experience) of when is good enough to close the option


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## humble_pie (Jun 7, 2009)

james4beach said:


> Thanks humble_pie for all these details... I am studying through this, will take me a while to absorb


.

is it a lot of details? so funny, for me it's something i gaze at in a twink.

here's the short summary. In XIU i'd rather not spend the $$ to buy that 14 strike submerged hippo. I rather spend much less money, buy the 21 strike in 2018 calls & kiss those bucks goodbye if the market implodes over next 22 months.

notice that atrpdocbiz says today that he put on diagonal spreads in AAPL & GOOGL, however his graphic won't open for me so i cannot see em.


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## james4beach (Nov 15, 2012)

Perhaps this is where my fear-of-loss really works against me. I just have so much trouble buying those OOTM strikes. How often does XIU rally *that* hard, to actually create such a massive gain?

I can't help but feel like I'm getting into a lottery ticket. But like you said... low probability of a very high return. Clearly it happens sometimes, but there are many expired losses along the way.

Perhaps such trades are ideal in non-reg accounts where you benefit from the capital loss of the OOTM calls that don't work out? Then you have cap losses to carry forward to the eventual home-run when the OOTM pays off big?


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## humble_pie (Jun 7, 2009)

today is zoo day. We have bisons under fire, hippopotamuses under water.

i don't want to give the wrong idea. I don't really like or play XIU options, they don't have enough premium, remember that you were the one who asked about em.

occasionally, when XIU is having a fire sale, i might buy 20 or 30 long calls. These are in addition to the 3300 shares i hold, against which i've also sold other call options with higher strikes.

altogether, a big yawn. Won't you please pay attention to option trades by atrpdocbiz. Much more interesting. He has much shorter timelines than i do.


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## james4beach (Nov 15, 2012)

Well getting back to how XIU options came up. I'm interested in some kind of leverage on the TSX that tracks XIU very closely.

Among the methods listed upthread, it seems that either traditional margin loans, or XIU options may be the best method. Any other good ways to leverage long the TSX ?


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## humble_pie (Jun 7, 2009)

james4beach said:


> Perhaps this is where my fear-of-loss really works against me. I just have so much trouble buying those OOTM strikes. How often does XIU rally *that* hard, to actually create such a massive gain?



only 2 long-term calls in XIU have been discussed, the DITM march 14s of 2018 & the slightly OTM march 21s of 2018.

in neither case do i see any massive gain. The 14s were all intrinsic value, only a few pennies of theoretical value. That was not a massive gain.

the 14s will continue to trade like that, at rock-bottom prices with no theoretical value. They are what are called 100 delta options, ie they are so deep-in-the-money that their own price trades in tandem with the stock, almost penny for penny, certainly dollar for dollar.

eg if stk rises to 22, the ask price for this option will likely run around 8.35.

turning now to the other call of march '18 being discussed - because it had significant open interest - this was a 21 strike, so with stock at 20.15, no massive gain was implied.

james if you are feeling uneasy, i know that you know that this is not quite the right move for you to be taking at the present moment. I'm not doing anything in XIU myself. I have a few shares, i've sold a few OTM calls that are fairly far OTM, about once a year i might speculate by buying more naked call contracts, although these will have strike prices much closer to the money.

there's also the selling of puts, which i'm not doing in XIU because i don't want any risk of acquiring more stock. But you could be a seller of naked puts in XIU. It's a legitimate way to proceed.


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## james4beach (Nov 15, 2012)

Maybe I should clarify something. I'm not planning to leverage long the market right now, so I'm not looking at an immediate purchase.

If I'm able to develop a method that has a chance of beating the index (I'm constantly working on this), I may want to use leverage.

For example I'm currently looking at a strategy that, using HXU, offers a good risk/reward tradeoff. I don't like HXU for this purpose as it doesn't track too well over longer periods, and that's why I'm considering other leverage methods. Then I will see how they work in my experimental strategy.


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## james4beach (Nov 15, 2012)

humble_pie and other option people, a question:

If we are assuming that the TSX always goes up long term, then why not simply _continuously_ invest in long dated XIU calls in buy-and-hold fashion? Even if you don't have the skills to trade them as humble_pie does, you would either:

- let it expire worthless (if it's a bad phase for TSX) taking your cap loss carry forward
- or enjoy a ridiculously huge gain (good phase for TSX)

Would this calls-only strategy outperform the TSX long term? Or is it difficult to estimate that?


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## james4beach (Nov 15, 2012)

For those interested in leveraged investing in the TSX, please also see this thread:
http://canadianmoneyforum.com/showthread.php/95793-TSX-Mini-Futures-(SXM)

20x leverage with no margin interest expenses... crazy.


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## james4beach (Nov 15, 2012)

For a while I thought that deep in the money calls were good for tracking XIU. But I think the flaw is dividends. Let's say XIU at $20 with a $15 strike call, deep in the money and nil premium.

Scenario 1: XIU total return +10% in a year
XIU starts at 20.00, ends at 21.60 with 2% dividend.
Your call's intrinsic goes from 5.00 to 6.60 or *+32%*
And your leverage is 32/10 = 3x the underlying

Scenario 2: XIU total return -10% in a year
XIU starts at 20.00, ends at 17.60 with 2% dividend.
Your call's intrinsic goes from 5.00 to 2.60 or *-48%*
And your leverage is 48/10 = 5x the underlying

Someone correct me if I'm wrong but that asymmetry seems like a big problem. This isn't "tracking" the TSX in a uniform way. The last thing you want when employing leverage is a methodology that _amplifies more on the way down_!

In comparison, a standard margin loan doesn't have this effect, because you're actually holding XIU and still get its dividends. Am I thinking about this in the right way?


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## andrewf (Mar 1, 2010)

I think part of the gap is that a -10% return is not as likely as a +10% return.


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## james4beach (Nov 15, 2012)

Interesting point about probabilities of these outcomes. If we only focus on the positive move, the tracking is beautifully linear at high leverage of your choice, easily 2x or 3x. I'm looking for something I can use in my RRSP for leveraged TSX exposure, and I've narrowed it down to either HXU or XIU calls.


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## humble_pie (Jun 7, 2009)

james4beach said:


> For a while I thought that deep in the money calls were good for tracking XIU. But I think the flaw is dividends. Let's say XIU at $20 with a $15 strike call, deep in the money and nil premium.
> 
> Scenario 1: XIU total return +10% in a year
> XIU starts at 20.00, ends at 21.60 with 2% dividend.
> ...





jas4 i don't have your math skills & admittedly my crumble is only a poor paltry dumb thing. Still, i'm not rolling out the same figs that you are.

where i don't agree with you is that you appear to be criss-crossing total return with current capital return figs over & over again. Plus you start criss-crossing right at the beginning. Let's look:



Scenario 1: XIU total return +10% in a year
XIU starts at 20.00, ends at 21.60 with 2% dividend.
Your call's intrinsic goes from 5.00 to 6.60 or +32%
And your leverage is 32/10 = 3x the underlying

_here's my take:

Scenario 1: XIU total return +10% in a year
XIU starts at 20.00, ends at 21.60 & pays a 2% dividend, which is .40. 
the current capital return on the stock itself (no dividend) is only 8%. 

the call option has gone from 5 to 6.60, for a 32% return, as you say. 

the total return on stock plus div is, as you say, 10%.
investor ends up with $22 in total return._



Scenario 2: XIU total return -10% in a year
XIU starts at 20.00, ends at 17.60 with 2% dividend.
Your call's intrinsic goes from 5.00 to 2.60 or -48%
And your leverage is 48/10 = 5x the underlying

_my take:

i see jas4's above calc as going wrong as of line 2.
XIU starts at 20 but ends at 18.40 because it only loses 8% (see scenario 1).
the $5 call's intrinsic value is now 3.40.

the option has lost exactly 32%, same as the gain in scenario 1.

in scenario 2 according to my calc, investor ends up with 18.80 (stk @ 18.40 plus dividend .40)
ie in a total return calc (capital gain/loss plus dividend) the investor who has lost in scenario 2 by the same ratio as the scenario 1 investor has gained, has actually only lost 1.20 or (6%).

meanwhile the leveraged option trader in either scenario has either gained 32% or else lost 32%._



there are a couple more subtle calculations .each:

1) in reality there would be option premiums. There would never be *nil* premium. But for simplicity's sake i'm happy to take $5 as the premium in jas4's example.

2) in today's astonishing low interest environment, the cost of margin is not too burdensome. However in normal times the borrowing cost of the capital required in the buy-stock scenario vs borrowing cost in the buy-option scenario would be substantial. Such cost must be figured into the calculation.


_"tis a poor thing but tis me own"_



.


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## andrewf (Mar 1, 2010)

No, for a total return of -10%, assuming 2% division, the underlying will fall in price by ~12%, or $20*0.88=$17.60.

Part of option pricing is treasury bill rates, so in a higher interest rate environment, the cost of leverage is baked into option pricing as well.


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## humble_pie (Jun 7, 2009)

andrewf said:


> No, for a total return of -10%, assuming 2% division, the underlying will fall in price by ~12%, or $20*0.88=$17.60.
> 
> Part of option pricing is treasury bill rates, so in a higher interest rate environment, the cost of leverage is baked into option pricing as well.



the divine & mystical harmony of 17.60 is hard to grasp, especially for a poor pie basking on the boathouse deck on a warm sunny labour day morning ...

all i can say is, if call losses are worse than call gains when all is said & done, ie held to expiration, then thank the lawd i've always been an option seller

.


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## andrewf (Mar 1, 2010)

But a -10% return is not as likely as a +10% return.


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## humble_pie (Jun 7, 2009)

it's a good thing we didn't have to live through the depression

jas4 loves the japan comparison, just imagine XIU calls in a 25-year-rising-sun-declining-markets setting

s.


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## james4beach (Nov 15, 2012)

Yes, a prolonged bear market would be very bad for this strategy (as it would be bad for any leveraged investor). But andrewf is right, all else being equal, the -10% return is less likely than a +10% return.

I have a silly little market timing algorithm I've been playing with and back-testing. Since 2005, my algorithm has given 17 time periods during which to go long, so I looked back at these to see which ones had _negative XIU periods that include a distribution_ -- since that is the situation where the XIU call suffers the most.

Only 3 of 17 periods had that characteristic, and that includes the '08 crash.


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## lonewolf :) (Sep 13, 2016)

james4beach said:


> Thanks everyone, yes I missed options, warrants, and futures. Massive leverage via futures.
> 
> I have often considered the idea of using long dated XIU call options as a way to stay long the TSX. Does anyone follow this methodology? I just don't know how to model such a thing.


 Use spy or SPX options more liquid plus from my experience often there are set ups where there is little to no premium only intrinsic value with option that are deep & far out in time.

Go far out as far as time as possible buy deep in the money so just buying intrinsic value or little premium. Of course best to do when option prices are low. Roll over position about one year before option expires. Market moves against you strike price moves closer to in the money premium will expand as intrinsic value decrease giving option positive curvature. Market moves in your direction price of option has no choice but move in your direction point for point. Sideways market no to little premium to tick away with time.


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## lonewolf :) (Sep 13, 2016)

I have seen set ups in SPY & SPX where you could use call leaps & put leaps @ the same time where both had deep in the money strikes with little to no premium. If bought both didn't matter which way market moved the positive curvature of both puts & call would make money unless of course the market went sideways. This set up is not always there though often it is.


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## james4beach (Nov 15, 2012)

I'm still trying to wrap my head around what you're supposed to do with HXU. Sure, on a daily basis it delivers 2x returns (today it gave 2.08x XIU)

But look at this two year period of HXU (in red) vs XIU (blue)
http://stockcharts.com/h-sc/ui?s=HXU.TO&p=D&yr=2&mn=0&dy=0&id=p01138676313

Can someone explain to me what's going on there? HXU delivered 2x return on the way down, losing twice as much as XIU. But after this down & up pattern, HXU ended up exactly where XIU was ... instead of returning 2x its return! That's kind of tragic.

So you get 2x amplification going down, but not up? Wow.


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## lonewolf :) (Sep 13, 2016)

james4beach said:


> I'm still trying to wrap my head around what you're supposed to do with HXU. Sure, on a daily basis it delivers 2x returns (today it gave 2.08x XIU)
> 
> But look at this two year period of HXU (in red) vs XIU (blue)
> http://stockcharts.com/h-sc/ui?s=HXU.TO&p=D&yr=2&mn=0&dy=0&id=p01138676313
> ...


 beta slipage


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## andrewf (Mar 1, 2010)

james4beach said:


> I'm still trying to wrap my head around what you're supposed to do with HXU. Sure, on a daily basis it delivers 2x returns (today it gave 2.08x XIU)
> 
> But look at this two year period of HXU (in red) vs XIU (blue)
> http://stockcharts.com/h-sc/ui?s=HXU.TO&p=D&yr=2&mn=0&dy=0&id=p01138676313
> ...


Sequence of returns risk/volatility decay. It rebalances daily.


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