ETF Options as Proxies -- Easier Said Than Done

Roger Nusbaum submits: A follow up question on the Sell in May post came from the person with 40% in cash. He wanted my opinion on buying call options (specifically long dated calls) on ETFs as proxies -- so that he can maintain the 40% cash position.

This gets very tricky very quickly. What strike do you want? How far out do you want to go? To try to make the following example simple, I am going to use very odd dollar amount.

The example will be with the S&P 500 SPDR (SPY). Lets say the entire portfolio is $15,000, about the cost for 100 shares of SPY. A strike of 90 is about 60%. A December 2009 call struck at 90 was offered at $62.70, leaving close to 60% in cash at the close on Monday. That strike is $58.92 in the money, so the buyer is paying $3.78 in time premium. If he chooses a higher strike, he will pay more time premium but tie up less cash in nominal terms.

Laying out that much cash may not be what too many people would want to do, but if he buys a 130 call for the same month he is paying $13.31 in time premium. You obviously have a much lower delta with the 130 call, so technically speaking one call struck at 130 doesn't really create the effect of, in the case, 100 shares. Really the 90 call probably only creates 95 or 96 shares of SPY.

Perhaps a combo of some sort creates what the reader is seeking?

Or does the reader want to maintain 50% in a "normal portfolio" and then use another 10% to replicate the other 50% by capturing the leverage available in the options market?

Let's assume a $100,000 portfolio with $50,000 invested. Can another $10,000 create $50,000 of equity exposure? Again what strikes and for how long? Looking at the SPY chain for December 2009, I don't see how it can done. I looked at a few other months but did not find anything there either. Again, it is possible that something creative could be woven together to create this idea but, on a casual glance I am not seeing it.

All of this, and remember you will not get any dividends, and whatever you pay in time premium will erode slowly.

A better idea might be to do something with a double-long fund from ProShares or maybe a 2.5 long OEF from Direxion Funds.

Another idea could be the use of a double-short fund. This can create being 60% long, but won't leave 40% cash.

It seems like the reader is intent on anticipating a big turn. This is very difficult to do, and the chance of being wrong is far greater than being right.

Comments

[hotta fire]

ok... so I am trying to understand this. Please correct me if I am wrong.

You said his options would be "$58.92 in the money, so the buyer is paying $3.78." So he's still got 60% of $15,000 in cash, or roughly $9,000. That $9,000 is in a money market fund (if he has a half-decent broker). Over 20 months ('till expiry of the call options) that money will surely earn a cumulative 4.2%. Maybe it falls short, and he can put that money in a risk-free investment and get 4.2% over 20 months, or 2.52% annualized.

Under my scenario he has gained exposure the SPY as if his entire $15,000 was invested (assuming he holds the options until expiration to mitigate the effect of the lower delta as you mentioned). The price he paid for this exposure is more than made up by the interest his $9,000 is collecting.

I don't see how is is a bad way to gain exposure SPY. The alternative would be to fully invest the $15,000 directly. But if I am thinking about this correctly, once you take into account the interest the $9,000 is earning, he will make MORE money buying the option than buying $15,000 of SPY.

Please correct me if I am thinking about this incorrectly.

[RogerNusbaum]

the reader in question is focused on 40% in cash which does not quite work out but you are right it may not be bad. The idea behind the post is that this is not simple.

[hotta fire]

And I guess my point is I don't see how this is particularly difficult. And even if someone thinks it is "tricky" I think it's worth the time and effort to figure it out because it looks promising.

[hotta fire]

I forgot to say where I got 4.2% from. 4.2% x $9,000 = $378.

[TimothyCollins]

Jordan...I see what you are saying, and actually agree with you. Also, I don't know that I'd want to go quite so far in the money. For clients over 59 1/2, we actually looked at fixed annuities as well that would allow 10 to 15% withdrawals (for rebalancing in additional to rate of return) and offered higher first year interest rates (in the neighborhood of 8%). The caveat here is the surrender charges and capped withdrawals, but you don't put all your cash here, and if you have the right annuity company, they will allow you to roll the annuity (with no compensation, but that is ok because it benefits the client) into another fixed annuity a year or two later, get the high start rate again, and just extend the surrender period. By withdrawing the 10% per year you are also constantly reducing the amount subject to surrender charges. Combine that with muni's, money market, or short term treasuries, and I think you have an argument.
Lastly, the only issue I see with Direxion or ProFunds is that they are "daily" leverage, so they are fine in an upmarket but struggle on the down days or the back and forth days, so unless you get a very good rebalancing/averaging strategy with them (just so happen to have one, but it is a lot of work), you won't get a true 2x or 2.5x on an annual basis.

[TristanYates]

Enjoyed the article. Some thoughts: Delta goes up as you hold the option, finally hitting 1.0 at expiry, so you get the full benefit of index ownership. Gamma rises too. Time value declines, slowly at first, and then more rapidly in the last few months. Dividends buy down the option cost.

It's a cheap loan basically, with dividends being applied to the interest costs. Leveraged investments have lots of interesting characteristics, such as having very high potential upsides, and the ability to go down to close to zero and them come back. They also have very high volatility. I'm a fan of leveraged investing, but wouldn't advocate it for everyone.

The 2X Direxion & Profunds have some long-term dangers related to their daily rebalancing. Check out the long term performance of some of the funds as compared to the underlying and there's some big underperformance.