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The present "endless joy" markets brought about by the Fed's actions are leading to the emergence of a new credo. In this credo, all that an investor has to do is buy an index, lever it and be happy forever. That this philosophy is catching on is obvious - margin debt numbers are again closing in on their historic highs set during past bubbles.

As an example of this new credo, Macro Investor has been writing several articles on how the average investor would be better served with buying the ProShares UltraPro QQQ (NASDAQ:TQQQ) - which replicates the PowerShares QQQ (NASDAQ:QQQ) daily returns multiplied by 3 - and just sitting back. In his latest "A Better Way to Invest in Technology," Macro Investor goes one further: he says that to mitigate drawdowns from the leverage, one just has to go out and buy 6-month puts on the TQQQ.

The need to buy these puts is obvious. Without them in the past decade, the strategy of just levering the QQQ 3 times has led to at least 2 drawdowns in the 95%-99% range. Retiring on a strategy able to produce that kind of drawdown is not something most are ready for.

So Macro Investor basically added the need to buy protective at-the-money puts regularly. In his eyes, this would mean that whenever there was a drawdown, these puts would limit it to around 15% of the overall portfolio. To arrive at this figure, Macro Investor consider the put cost (10%), some financing charges (2.5%) and some variability in put cost over time (2.5%).

I am writing this article, however, to say that there is a problem. A huge insurmountable problem.

The problem

When Macro Investor considered the cost of his puts in his model, he took the present price and applied a similar cost all the way back. With TQQQ trading at $57.56, the present price of a close to at-the-money put with June 21 maturity is $7.60 for the $58 strike, of which $0.44 is intrinsic value, so let's consider $7.16. This is 12.43% of the underlying's value, so a bit more costly than what Macro Investor considered. However, the main problem is quite a bit different…

You see, the put price moves with volatility. It moves significantly with volatility. The more volatile the underlying is, the more likely it is to end up far from today's price. And it so happens that today's volatility, given the Fed's actions, is rather low historically. Below, we can see a chart of VXN, an index expressing the volatility of options on the QQQ (Source: Yahoo Finance):

(click to enlarge)

As we can clearly see, we're at historic lows (13.89%). In many instances in the past, we've seen volatilities 3-4-5 times higher than today's. Sometimes, like in the early 2000s, those higher volatilities lasted for years. This would have severe consequences for the costs of the supposed protective puts Macro Investor would be buying. And that is the main problem.

How severe is the problem?

We can actually quantify just how severe the consequences of higher volatility could be. First, let us model the costs today to see if we come close to the market price. For this we will be using CBOE's Option Calculator, using a 180 day at-the-money put (100 price, 100 strike to make it simple, the put price will thus come as a % of price).

At 13.89% volatility

(click to enlarge)

This gives as a price for the put of 3.8%, since we'd have to lever it 3x, that would be11.4% - not far from the 12.4% the real market is quoting us today, validating the method.

At 30% volatility

(click to enlarge)

This sets us back 8.3% - which means our 3x levered protection would have a cost of 24.9%, already wildly over the cost considered in the model - 15%.

At 60% volatility (which coincidentally, one would be paying at the end of October 2008)

(click to enlarge)

Now the flying detritus really hit the revolving wind propeller. The option would cost 16.5%, which 3x levered comes to an eye-popping 49.5% of the account needed to protect it from possible devaluation.

It's pretty clear that considering one would be paying 15% to keep a 3x levered bet on the QQQ protected is deeply unrealistic. Such thought emerges from an environment where perception of the option costs has been distorted by low volatility. The real costs to keep such a bet protected would be massive and unsustainable, as this short exercise shows.

Conclusion

The idea that one could keep a levered bet protected by cheap puts does not make sense. The huge drawdowns that such a bet can provide are thus rather unavoidable - no one would be ready to pay almost 50% of his portfolio as insurance at some point.

The present artificially-induced low-volatility environment greatly distorts the notion of risk in the markets, leading to ever more leverage being applied. As the artificial support is removed - or maybe even sooner - the excess leverage might lead to the traditional consequence: forced liquidation.

Source: Not Necessarily A Better Way To Invest In Technology