Post New

I wanted to share a strategy I read about.
Leveraging Options for Enhanced Returns: A Strategic Overview
In the realm of investment strategies, a particularly intriguing approach involves the use of options to potentially amplify returns compared to directly investing in the SPDR S&P 500 ETF Trust (SPY). This method, which we might have touched upon briefly, warrants a deeper exploration for its innovative use of Deep In-The-Money (DITM) call options.
The Core Strategy with Call Options

Rather than purchasing SPY shares outright, this strategy advocates for buying a one-year DITM call option on SPY. Key to this approach is selecting an option with a delta of one, ensuring that for every $1.00 movement in SPY, the option's value also adjusts by approximately $1.00. The target strike price is about 60% of SPY's current share price, with the aggregate cost (strike price plus premium) ideally less than 1% above SPY's trading price, minimizing the time value.
Entry and exit points are dictated by moving averages: enter when the 10-day moving average exceeds the 200-day moving average, and exit upon the reverse. As SPY appreciates, the strategy involves "rolling up" the option to capture gains, and "rolling out" to a new one-year option around 30 days before expiration. This maneuver aims to leverage market upswings, potentially tripling the returns of SPY.

Adapting to Market Downturns with Put Options

The strategy extends to bear markets, triggered when SPY declines by 20% from its peak, reflecting a shift to more defensive trading postures. Here, the focus shifts to DITM six-month put options on SPY, mirroring the call option strategy but inverted for bearish conditions. The entry signal is a MACD histogram below -0.5, with an exit signal above 0.5. Re-entry criteria include the 10-day moving average trailing the 20-day, alongside a MACD histogram below -0.5, the market being 20% or more below its high, and spy being below the 200 day SMA. 10-day moving average trailing the 20-day ensure responsiveness to bear market volatility.
Risk Management and Potential Outcomes

While the strategy is designed to magnify gains, it's not without risks, including the possibility of being "whipsawed" by rapid market reversals. However, the structured entry and exit signals, combined with strategic rolling of options, aim to mitigate these risks, potentially leading to significant gains over losses, as suggested by the referenced strategy.
This dual-faceted approach, integrating both call and put options based on market conditions, embodies a sophisticated strategy to navigate and capitalize on market dynamics. As with all investment strategies, due diligence and a clear understanding of associated risks are paramount.
Thoughts appreciated.

I would have serious doubts that a crude MACD timing signal adds enough value to get the timing right.

And also serious doubts about their estimate of the cost of the leverage. You're getting a loan to buy something, and the interest you pay is not inconsequential.
Remember that when buying SPY calls rather than SPY, you don't get the dividends. So your true cost for the borrow is the visible time premium in the option, PLUS the foregone dividends.

Getting in and out of option positions as frequently as the suggested timing signal implies would eat you alive in trading costs.

So, overall, I would be pretty darned dubious.


However, I can definitely see the potential merits of using deep in the money call options for leverage.
("Leverage: the only way smart people go broke" -- Mr Buffett)

Over the years I have done very well with leverage, most often using deep in the money call options in recent years.
My key rule of thumb is this: FIRST pick the absolutely steadiest, most rock solid, and above all predictable underlying asset. Not necessarily steady in market price, but steady progress of visible value, now and somewhat into the future.
THEN (and only then) consider adding leverage.
Don't worry if the rate of return from the underlying asset isn't that fantastic. Even a little bit of leverage, say 1.5:1, turns a ho-hum rate of return into an excellent one.

Leverage should be used only when the borrowing meets three criteria:
* It's not callable. This rules out broker margin loans. The leverage built into call options is OK--the counterparty can't ask for the strike price, it's YOUR option.
* It's cheap enough. The implied interest rate varies, so there are years it makes sense and years it doesn't. Just don't do it in years it doesn't make sense.
* It's long dated. You want time for your investment thesis to work out, whatever it might be. LEAPS are in the middle: not short term, but not long term. They don't meet this test, but they are pretty close. The risk is that when it comes time to roll your options they might not be available, or might not be cheap enough. It is not a big enough risk to keep me from doing it.

As many know, I make my living primarily by buying long dated deep in the money calls against Berkshire Hathaway. Both the underlying security and the method of leverage were picked using the rules of thumb above. The business is easy to value, and pretty predictable in its value trajectory, and cheap enough often enough that wanting to use leverage makes sense. (not today however--not cheap). For 22.5 years my average profit in a year has been 28% of the average capital I have had at risk on an average day. (The stock has returned 10.3%/year). The returns from year to year are very irregular, but does that really matter?
The advantage comes mostly from the leverage in calls, but also from some buying low and selling high repeatedly. It got REALLY cheap for a while there around 2011-2012, and I really piled in up to my eyeballs. Consequently I made more money in 2013-2014 during the rebound than I did in 2001-2012 combined, pushing up my average return numbers.

Jim

First, thank you very much for your well thought out reply.


I would have serious doubts that a crude MACD timing signal adds enough value to get the timing right.

That is only for the bear market part of the strategy. For the bull market part, she uses the 10 day crossing the 200 day sma.

So your true cost for the borrow is the visible time premium in the option,

She claims that when you go DITM, the time premium + the strike price can be less than 1% higher than spy. Basically zero borrowing cost.

Maybe I should just do it on brk.b, since I know this works.

Have you tested the 10/200 timing signal to see if it adds value with a stock or ETF?

She claims that when you go DITM, the time premium + the strike price can be less than 1% higher than spy. Basically zero borrowing cost.

No, I suspect that her estimate is a bit crude. She probably forgot about foregoing dividends, at a guess.
Or looked at a time stretch that interest rates were pretty low. There is no such thing as free uncallable leverage.

Check a quote and check it yourself. Don't use the "last" price, though, look at midpoint of bid and ask while the market is open.
If you're buying that call for SPY, you'd probably have to pay 20% of bid + 80% of ask. Add the strike, add the dividends expected from SPY before expiry, and compare the total to the price of SPY. I'll wager the "extra" with the options works out to a lot more than 1%/year. More like 6%/year on the "borrowed" money, at a guess.

For someone wanting to go long the broad index with some leverage, and with potentially some trading, E-mini index futures would be the more obvious way to go. They are almost free to trade because of the low commissions and super tight bid/ask spreads. And there is no "extra" price built into the price for volatility: they tend to track VERY closely the current index level, plus the short term interest rate till contract expiry, minus the regular dividends expected before expiry. Futures allow much higher leverage than call options...the trick is to COMPLETELY IGNORE that opportunity and don't use much leverage, keep a lot of cash around. An index can drop by half at any time, and the cash will disappear from your account minute by minute. It might be worthwhile to buy some very deep out of the money put options as insurance against a REALLY huge drop so your cash pile is never a bit too small because of the modest leverage you're using---since that's so rare, the insurance is pretty cheap.

As for the timing, my suggestion would be not to use the scheme long/short, but long/cash. (well, my actual suggestion would be not to use the scheme, but that's a different conversation). Make a good bullish wager when the omens are good (preferably multiple omens, all of them). And just sit on your duff the rest of the time.

Jim

I got the XSP Mar'25 300 call for 213.15 when bid = 210.95 and ask = 214.51, for a spread of 3.56. XSP was 501.17. FWIW, today the spread is 1.48.

That was 62% into the spread, just a little above the midpoint of 212.75. 3/4 of the spread was 213.60
I moved up my limit by 5 & 10 cents as a time, starting at 25% of the spread (211.85), waiting about 30 seconds at each step until it got filled. When they like your price it fills immediately.

The effective interest rate was 3.80%. Breakeven is 513.15.

The "extra" comes to 2.19%/yr. Indeed more than 1%/yr.

I think I mentioned earlier that I like calls on XSP better than SPY because of the English expiration, cash settled, and no fiddling for dividends.

I think I mentioned earlier that I like calls on XSP better than SPY because of the English expiration, cash settled, and no fiddling for dividends.

Can you explain that dividend comment?

I presume you mean XSP the ticker for mini S&P options, not the "iShares Core S&P 500 Index ETF (CAD-Hedged)".

If it's tracking the index value, then a delta-one long position in this is getting [index change] whereas a long position in SPY or similar is getting [index change + dividends]. Much like a futures position.
So in comparing the two, the index option would be more expensive (i.e., giving you lower return) even at the same price, no?
Therefore your incremental cost of the leverage is not just the price premium ([execution + strike] - index value), but the price premium plus the foregone [after tax] amount of the dividends in the same period, I would have thought.

Jim

Have you tested the 10/200 timing signal to see if it adds value with a stock or ETF?

I have not, but in the book, it is backtested, and all trades are listed.

I would backtest it either on an ETF or three (SPY,QQQ,IWM) or some stocks and see if it adds value. If it doesn't then I don't think it will enhance the options trading.

As many know, I make my living primarily by buying long dated deep in the money calls against Berkshire Hathaway. Both the underlying security and the method of leverage were picked using the rules of thumb above. The business is easy to value, and pretty predictable in its value trajectory, and cheap enough often enough that wanting to use leverage makes sense. (not today however--not cheap).

Jim, would you care to remind us of your cheapness criterion for BRK, and where the threshold stands today?

Elan

Elan, I am trying to learn more about options.

Can you explain the 30/60/90 strategy?

IIRC Jim's "cheap zone" is 1.2 PBV

Can you explain that dividend comment?
I presume you mean XSP the ticker for mini S&P options,

Yes, mini S&P options.


I do not really understand what difference dividends make, to this long-dated DITM calls strategy. Everytime I try to think about how to account for dividends I just get dizzy. (Luckily BRK does not pay a dividend, so that makes it simple on BRK calls.)

Since the market does not hand out free risk-free money, and since the market discounts all known information, then I assume that option prices already take into account the known dividends. Apparently it makes a difference when/if closing an option at an ex-dividend date---but that's not what I am doing.

It appears that the SPY dividends in the below holding period (2/16/24 - 3/21/25) will be $6.63.

===========================================================
For the 300 call expiring 3/21/2025.
At the time I grabbed both quotes on 2/16/2024

XSP was 501.17. Mid of bid & ask was 212.75
202.01 Intrinsic
12.54 TimeVal (est)

SPY was 502.01. Mid of bid & ask was 214.55
201.17 Intrinsic
11.98 TimeVal (est)


Assuming a 10% gain at expiration:
XSP will net (501.17 * 1.1 -300 -212.75) = $38.54
Gain = 18.1%

SPY will net (502.01 * 1.1 -300 -214.55 ) = 37.66
Gain = 17.6%

I do not see any effect of the SPY $6.63 dividends. Maybe the comparison of SPY underlying vs. SPY calls will be a different comparison. But that's not what I am comparing. I am looking at XSP call option vs. SPY call option.
[Yes, SPY itself will have had the 10% gain PLUS $6.63 dividends.
So the gain is (552.21 + 6.63)/502.01 = 11.3%. ]

I view these two outcomes as essentially identical. In that case, I prefer XSP because it is cash-settled and English expiration.

Maybe the comparison of SPY underlying vs. SPY calls will be a different comparison. But that's not what I am comparing. I am looking at XSP call option vs. SPY call option.

Yes, I was comparing the option to the long stock (fund) without leverage. Because that discussion was about the total cost of the leverage.
The strategy as described, if I followed it correctly, was based on very unrealistic estimates of the cost of the leverage. It isn't going to be anywhere near 1%. In general switching from stock to ITM calls will hit your breakeven by the prevailing interest rate on the strike, plus the foregone dividends on the entire position, plus more based on the moneyness/optionality/implied volatility.


Random example, (as you note it doesn't make much difference which options you're using)--SPY versus SPY ITM calls.
SPY closed at $512.01.
In the next year the market has $6.55 in anticipated dividends baked in, in effect reducing your breakeven a year from now to $505.45. By comparison, a $250 March 2025 call on SPY with about 2:1 leverage would cost you (midpoint) around $270.85, for a breakeven of $520.85. A buyer would pay a bit more because of the bid/ask gap, but let's ignore that.

The difference in breakevens between buying the stock and buying the call is $15.39. The amount of money you have to put up today differs by $241.16. So, in effect, you're paying interest of $15.39 on a loan of $241.16, which is 6.381%. Expiry is just a hair over a year away, so that's about 6.11%/year annualized rate. i.e., the roughly half portion of your position which is "borrowed" (the leverage part) has to rise by that rate before you break even.

(For myself, I calculate the implied loan rate to be a tiny bit lower, because I use the after-tax amount of the dividends foregone when estimated the "loan" cost. I pay 30% on US source dividends, so in reality I'm not foregoing as much if I opt for calls rather than stock)

Jim

The strategy as described was based on very unrealistic estimates of the cost of the leverage. It isn't going to be anywhere near 1%.

Yes. That 1% claim was absurd. It makes me suspect that the author had never done the strategy, just pulled figures out of thin air. A lot of investment authors clearly just make stuff up.

FWIW, in 2021 I was seeing implied interest rates in the range of 2.5% - 3.7% on BRK.B calls. But in 2023 & 2024 they are 6% - 6.5%.

The rates on these SP500 calls were 3.8% (XSP) and 4.0% (SPY).

Can you explain the 30/60/90 strategy?

I suppose you mean the 6/3 Options strategy - Select stocks with good price appreciation prospects over the next three months, buy call options that are six months from expiration, and sell them after three months.

More specifically, I start with the 400 stocks ranked T1-T2 in the VL universe. I rank them by RRS126-2s, i.e. Regression Relative Strength over the latest 126 trading days, minus 2*each stock's price volatility over the last year. IOW, seek the stocks with highest momentum adjusted for volatility, lower volatility is better. Eliminate from the list the 10% of stocks with highest total return over the last 5 trading days. Recent extreme strength is not a good sign for short term future returns.

Buy options on the top 5 stocks produced by this screen. I list the top ten, and pick out of them the ones that have tradeable options (most do), for which I don't already own call options. I look for options that expire 6 to 8 months forward, and a strike price between 0% and 10% OTM.

I do this every month on the Monday after option expiration. I sell the options that I've held for three months and buy the new set.

As a matter of risk management, I run this option strategy in a separate account in which I do no other stock trading. 1/3 of the account is held in options and 2/3 in cash or equivalents. At each monthly cycle this 1/3-2/3 balance is restored by buying new options in an amount equal to 1/9 of the current total account balance.

Elan

Elan, thank you very much.

Yes. That 1% claim was absurd. It makes me suspect that the author had never done the strategy, just pulled figures out of thin air. A lot of investment authors clearly just make stuff up.

Are you saying that you cannot achieve a time value of < 1%, or the (strike + premium)/stock price - 1 < .01?

"Yes. That 1% claim was absurd. It makes me suspect that the author had never done the strategy, just pulled figures out of thin air. A lot of investment authors clearly just make stuff up."

Are you saying that you cannot achieve a time value of < 1%, or the (strike + premium)/stock price - 1 < .01?

Arghhh, can't select/cut text from the kindle reader app. Can't search on "1%", either. It ignore the "%" sign and just searches for "1".

Anyway..... she says "effective price less than 1% away from current price".
Effective Price = strike + premium.

For some reason she seems to think that option volume has some importance.

She gives examples of 1 year DITM (~50% ITM) SPY calls with time value 0.5% of the option price. She says to shoot for less than 1%.

But when I look at current SPY options, I get more like 3.5% time value.
SPY MAR 21 '25 $255 CALL ($266.00 mid between bid & ask)
Time Premium 9.065
Intrinsic Value 256.72
9.065/266 = .034 = 3.4%

EP = 266 + 255 = 521.00. SPY is 511.72.
(521-511.72) / 511.72 = 0.0181349175 = 1.8% = almost twice the 1% she says to look for.


Not saying that the idea is all wet, just that her figures are unrealistic.

Not saying that the idea is all wet, just that her figures are unrealistic.

Well, in the book she mentions that people sell you these complicated seminars teaching you how to get rich with some trading system, and they get rich selling you the system, not using it. Perhaps she is talking about herself.

What is your LEAPs BRK strategy? I thought I saw a post outlining it once but search didn't find it. Like when do you buy/sell, what allocation vs Stock vs cash? Any insights appreciated.

What is your LEAPs BRK strategy? I thought I saw a post outlining it once but search didn't find it.

My proposed mechanical strategy goes like this:

Buy a large allocation of Berkshire stock. Preferably on a day it's not more expensive than usual. i.e., not today.
If/when it gets below 1.35 times book, sell half the stock and put the money into Berkshire options offering 2:1 leverage. Longest dated for sure, lowest strike or near the lowest strike.

Next time it gets above 1.55 times book, sell the calls, and put all the proceeds back into plain stock.

If you get within a couple of months of expiry and the valuation still hasn't reached the 1.55 target yet, roll them out: sell the calls and buy similar ones expiring two years later. It's very unlikely you'll have to do this more than once, normally the valuation level gets pretty good for at least a brief period in any four year window.

The general idea is: when cheap, go to 1.5x leverage. Next time valuation is good, go back to 1:1 (no leverage).



Another much more aggressive approach: Pick a big allocation, but not ALL your money. Put half your allocation into the longest dated, lowest strike calls. Put the other half into calls expiring a year earlier than that.
Each time a bunch of calls get within 1-2 months of expiry, sell them and buy different calls expiring two years later. (so you're only every rolling half the position in any given year). Try to do your trades on a day when the stock price is high and the market is calm. If you can't do that, then you may need to cough up more cash to do the roll. (that's why you don't put ALL your money in this strategy). If the stock price is quite high, you can roll up to higher strikes and still get a fairly good implied interest rate, so you free up cash.
That's it. Do it forever, or at least until they stop offering options, or the interest rate built into them is too painful. You will occasionally have up five years with no gain, but on the other hand you will probably make a LOT of money on average over time. From time to time you'll be rolling up to a higher strike, so the strategy will throw off cash while you never reduce the number of shares you own. This is very aggressive, but on the other hand it has worked for me for a long time : )
I'm running at something like 23.5 years at around 26% IRR, mainly through a mix of buying lots when it's cheap, lightening up when it's expensive, and using the leverage built into calls. But I've had a five year stretch of zero return along with gritted teeth. It's not complicated, but it's hard. My position isn't worth any more than it ever was...I simply spend the month it throws off : )

Jim

Do you use book value from the most recent quarterly earnings? Or massage it somehow?
If I google around, p/b seems to be about 1.7 or so at the moment, after a pretty good runup lately.
For example https://www.financecharts.com/stocks/BRK-A/value/p...

Put half your allocation into the longest dated, lowest strike calls. Put the other half into calls expiring a year earlier than that.


Hmmm. At Sunday with markets closed,
The Jan'27 230 call is 308, so that would be $30,800 per contract.
230+308 = $538. Current price 514.
55% ITM, 6.24% effective interest rate.

For the year earlier, Jan'26. Would that be the deepest strike, 190 or the same strike, the 230? Or the same contract price?
The 190 is $334, the 230 is $295. Roughly the same interest rate.

So we're talking about $63,000.
Not bad leverage, though, about 1.6X.
Although at P/B of 1.7, this may not be the optimal time to buy calls.
But then, selling out of BRK at the "nosebleed high" of 400 wasn't a particularly great move.

a bunch of calls
Bunch! LOL.

Q: What do you do when you need to go to the store but your Maserati has a flat tire?
A: No problem, take the Ferrari.

(I slay me.)

Post New

Berkshire Hathaway FAQ

---

Contact Shrewd'm
Contact the developer of these message boards.