Can ETF Options Offer Cheap Leverage to Reliably Boost Returns?

I have been thinking about a conservative and reliable way to beat the market and I think I’ve found a way to do it. Hear me out because if I am wrong I would like to know why. This idea makes a lot of sense to me, but it seems too easy.

Let’s say I want to buy 100 shares of SPY to gain exposure to the S&P 500. But then I realize I can do one better. I can beat the index. How, you ask?

Beating the S&P 500

To beat the S&P, I would buy options on SPY which would give me exposure to the S&P 500 as if I bought 100 shares. Specifically, I would buy 1 option with an expiration date that coincided with my investment horizon and that were well in the money.

For this scenario let’s say I buy 1 of the 120 March 08 calls at $34.80, for a cost of $3,480. Plus commissions, that’s $3,482.95, where commissions are $2.95 per contract. It should be noted that I’d be paying a $388 premium for the option, but this comes with several benefits. First, my losses are capped at $34.80 per share. This limit on losses has a value although it is hard to quantify. Second, I’ve freed up the remaining $11,609.05, which can be invested in a money market fund which will yield about 5% annually, or 4.2% from now until March 2008. That translates into $483.71. You should be able to find other low risk ways to invest this money which can further boost your returns.

But my key point here is that in March of 2008 I will own 100 shares of SPY. If my option was in the money then I’ll just exercise it for the $5.00 fee. I’ll use the cash in my brokerage account ($11,609 + $483) to buy the shares at $120. If it is out of the money, then I will see another benefit of the option and will have limited my losses. I’ll still buy the shares, but at a price lower than $120. The worst case scenario, provided I earn the expected money market returns and hold the option until expiration, is that I come out 0.6% above the S&P 500. This may not sound like much but if you consider the S&P 500 typically returns about 7%, this is a 10% increase in performance. It also offsets the ETF expense charges.

It should be noted that my day-to-day portfolio value would not change exactly as the S&P 500 would. This means that I risk facing losses if I sell the option before expiration. But I don’t intend to sell the option, and most cash needs could be met by the cash in the money market fund.

The Premium is the Cost of Capital

I can frame this scenario in another way. $388 is the premium I pay to have access to the $11,609 for 10 months. This represents a cost of capital of 3.34% (4% annually), which strikes me as being very low. Certainly it is much cheaper than debt – either from the bank or your broker. Also, if I’m a good investor I can make much more than 3.34% in that time. In fact, I don\'t even need to keep that money in my brokerage account, as I would if I was buying on margin. I could make a down payment on a house and put aside some income over the next 10 months to put back in the brokerage account.

I picked a 10 month time horizon for this example but if you can bear a longer time horizon of 2 years, then the cost of capital further decreases. Experiment with deeper in the money options and it lessens still. And if you use a longer time horizon then you can seek higher/riskier returns on the remaining cash. Why? Because it is more likely you can make up any short-term losses by the time you need the cash, when you exercise the option. It should be noted that although you don\'t have to exercise the option, I have used it in this scenario to try and best explain the related risks.

I welcome your thoughts on this issue. Have you tried this and what additional risks do you foresee?

Comments

[Roderick Ba...:]

I did this on CISCO leaps during the tech boom and made a lot of money. You have to be patient and in the end I did have to get out as market boom ended. Otherwise, it is a way to make easy money.

I have never found for Free a service that plots option prices. That would be nice. Also, you much know basics of options.

Rod Baldwin

2007 May 08 10:51 AM

[Susan:]

This idea is not new. If you want to take it further (more diversifiation and longer time horizons) see indexroll.com
-- Susan

2007 May 08 11:26 AM

[jbs:]

Thanks for the feedback. I was not naive enough to assume that other people haven't thought of this, but I've just never heard it framed this way before. Specifically, I think there is something to be said for thinking of option premiums as the "cost of capital."

i.e. If you have stocks already you can convert them to options, essentially getting an unsecured loan until the leap expires.

Jordan

2007 May 08 11:55 AM

[Tristan Yates:]

Hi Jordan. I like call options a lot because you don't get margin calls and can sidestep market declines. Also note that you wouldn't get dividends from the underlying- these are used to "buy down" the price of the option. That's partly why the carrying cost is low.

BTW This is called a "stock substitution" strategy, using derivatives in place of stocks, and it works well in low volatility environments. When the market's very chaotic, the price of those long options goes up and cuts into your profits.

2007 May 08 12:20 PM

[jbs:]

Thanks Tristan. IndexRoll.com has some great content.

I encourage other readers to take a look at the site if they found my original article interesting.

2007 May 08 01:02 PM

[Luck-o-the-...:]

I agree the indexroll.com has some great content as well. I've been backtesting the idea with a little more "spice" (for more aggressive investors). I've played with the notion of using bull credit spreads (using puts) on a bi-monthly or quarterly basis/measurement. These would be out of the money, pretty far out of the money. You have the cash to back a purchase if necessary, but the spread limits downside of selling puts. Furthermore, these is some interesting research on rebalancing based on portfolio moves (i.e. trigger points of portfolio drifts of either 10%, 20% 30%, etc) but doing so on a consistent review (i.e. each week or every two weeks) using those trigger points to increase or decrease positions. Also, I'm putting together different tests on how far ITM the calls should be in a range of 10% to 20% using historical performance as a starting tool. Basically, if we are assuming the same number of contracts (so dollar difference, same share exposure), then shifting from a 10% to 20% or vice versa, in a scaling step (ie 10% to 13% to 16.4% to 20% or the other way) based on the prior year's movement. Going to a lower ITM, hence less downside if the market has had "x" number of up years in a row or moving to a 20% ITM if the market has 3 down years in a row (the S&P 500, for instance). The choice here is to move further ITM to capture a delta as close to 1 as possible or you could purchase additional 10% ITM contracts for added leverage if you are bullish (could buy less if bearish). You could employ this idea on the credit spreads as well. I've also solved the commission problem here, so that is out of the way. This is a work in progress, but backtest results on the S&P 500 from 1987 to 2007 has been very encouraging. Backtests from 1994 to 2007 showed cumulative returns almost double (assuming 5% on the fixed account), and annual returns about 375 to 525 bps higher. As always, I welcome feedback, good or bad. This is a work in progress, and I take all feedback, even if it is critism, so that I can improve upon strategy.

2007 May 09 09:55 PM

[kapil1022:]

Jordan,

The thing you forgot was the dividend on SPY that you would not receive by owning the call. If you factor this in, you will see that you are actually paying for the downside protection. Your position is equal to being long SPY and a march 120 put.

Kapil

2007 May 10 03:43 PM

[granger:]

I have utilized this idea in the past on individual equities. It works very well, especially on longer term options (LEAPS). Instead of a money market for the remaining cash, I have used the Income Fund of America from American Funds. Cash looks good here though with the ability of getting 4.75-5% risk free.

Thanks for the idea. Not sure why, but I never considered using this approach on an index ETF for broad market exposure.

2007 May 13 05:12 PM

[Kyle:]

There seems to be a fundamental flaw in this analysis that you're ignoring dividend payouts for the etf. Spy normally pays ~2% over your time horizon which you don't get while holding the option that you would have received if you had actually bought the stock

2007 Sep 28 03:38 PM

[Surya:]

Jordan,

What you have discovered is the basis behind valuation of options (risk-free abritrage). You can sythetically create an option by borrowing money and buying stock with the leverage. As Kapil1022 and Kyle pointed out above, your cost of debt would be effectively lower because of dividends you receive on SPY. Try the same analysis on a stock that has no dividends.

2007 Oct 14 02:03 PM