How An Individual Investor Can Take Advantage Of QE3

Includes: SPY
by: Derek Tomczyk, CFA

The Federal Reserve is not mincing any words. They have been following a loose money policy for the last 4 years and they want all of us to know that this will continue for at least another 3. The recent moves by the Federal Reserve should be no surprise for anyone who understands the Fed's mandate and approach to policy. The Fed is primarily trying to push people from safe haven assets and savings accounts and into riskier but more productive assets.

What the Fed is trying to engineer is a reversal of the following graph.

Federal Reserve M2 Velocity of Money

They want increased velocity of money and this can be accomplished by getting people to buy investments that in turn generate more spending and investment. In theory buying treasuries could fall into that category if the government could invest productively but politically the government is unable to use this cheap money anyway. Therefore in the latest QE the Fed is actually actively trying to get the private sector to use this money instead. This is in part why they gave such long term guidance and why they are now also buying MBS securities. They are trying to signal to you, the private investor, that interest rates are not going up anytime soon.

There is much discussion in political circles about whether this money printing is morally or ethically right. This is all fair and good, but to the investor, very irrelevant. The only thing that matters is to understand the situation and find a way to take advantage of if to generate return.

Therefore don't fight the Fed and instead do what the Fed wants you to do and borrow at near-free rates to buy productive assets.

Here are a couple of relatively simple ways to do so:

Sell treasuries short to "borrow" money for free

The immediate impact of the loose money policy is to keep treasury rates low. In fact treasuries under 5 years are yielding near 0% which means the government is borrowing essentially for free. What not everyone realizes however is that this means they can do the same.

If you short sell a 1 year treasury bill you will get the entire principal in cash while being responsible for the 0.17% in interest the investor who bought this bill should be getting from the government. You can then use the principal money to invest in stocks or ETFs.

The principal downside of this strategy is the margin risk. For example, when you short sell treasuries and buy an ETF, the ETF becomes the collateral. If the treasuries increase in value (your loan increases) or the ETF falls in value (your collateral value decreases) past what your margin can tolerate you will be responsible to fund the difference or pledge more collateral.

In addition there are fees associated with the borrowing of securities and possibly interest on any margin borrowing caused by market fluctuations.

I find the following approach far less risky.

Buy call options on stocks/ETFs

When you buy a call option in-the-money you are indirectly paying a small down payment on a fixed rate fixed term loan. This implied loan carries with it interest and needs to be "repaid" on the expiration date.

Since the fed has made its move the SPY 135 CALL expiring on Oct. 21, 2012 has an implied APR of -0.08%. This means someone is actually paying you to borrow from them. The SPY 135 CALL expiring on Dec. 21, 2012 is a bit more expensive but at 1.67% APR it is still one of the cheapest ways to borrow money. Here is the entire option implied APR curve from Sep. 14, 2012:

SPY Option APR curve $135 strike - Sept 14, 2012

There are a number of advantages to this strategy over the shorting of treasuries.

1) There is no possibility of a margin call.

Regardless of what the investment does you will effectively only pay the time value of the option to the option writer.

2) You can earn interest on the money not invested in the option.

A portion of the implicitly borrowed money is sitting in your account and can be invested in a short-term investment of your choice. This should preferably be something close to guaranteed such as a short term bill.

3) Should things go badly you have absolute protection at 135 (8.33% below Sep. 14, 2012 market price).

Regardless of what happens to SPY you can only lose the option premium you paid. This means the rest of the money is safely in your account and there is no danger of a margin call forcing you to close your position early. You can calculate exactly the amount you want to risk and how much you want to leverage yourself.

Of course not every option chain will offer yields as low as the SPY option chain. The value of the protection may be higher for riskier investments and translate into higher implied APR. The riskier investment however also runs a higher chance of a margin call in case of shorting treasuries. Therefore it may be worth paying a few basis points to avoid this risk.

In the end either one of the above strategies allows the individual investor to take personal advantage of the Federal Reserve loose money policy. After all, the Fed is not a bad ally to have on your side.

Disclosure: I am long SPY, QQQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.