Wiley Trading ENH A NCED INDEXING STR ATEGIES Ut ilizing Fu ture s and O p tions to Ac hieve Higher Pe r formanc e Tristan Yates
Enhanced Indexing Strategies
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Enhanced Indexing Strategies Utilizing Futures and Options to Achieve Higher Performance TRISTAN YATES John Wiley & Sons, Inc.
Copyright C 2009 by Tristan Yates. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: Yates, Tristan. Enhanced indexing strategies : utilizing futures and options to achieve higher performance / Tristan Yates. p. cm. (Wiley trading series) Includes index. ISBN 978-0-470-25925-2 (cloth) 1. Index mutual funds. 2. Stock price indexes. 3. Investments. 4. Portfolio management. I. Title. HG4530.Y365 2009 332.64 5 dc22 2008019098 Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1
Contents Preface xi CHAPTER 1 Owning the Index 1 The Story of Indexing 1 Indexing: Strategy or Philosophy? 3 Active Investment Selection 3 Index Investing and the Efficient Markets 4 Reconciling Indexing and Active Investing 5 Index Risk and Reward 6 Drift and Noise 7 Momentum, Mean Reversion, and Market Cycles 8 Cycles and Regime Change 12 Understanding Volatility 14 High Performance Indexes 18 Small Cap and Value Premium 19 Stock Migration 23 Additional Factors 25 Forecasting Index Returns 27 Summary 27 CHAPTER 2 Applying Leverage 29 Leveraged Investments: Conservation of Risk 29 Using the Leverage Ratio 32 Underwater Investments 34 Debt and Interest Effects 38 v
vi CONTENTS Sources of Leverage 39 Margin Loans 39 Futures 41 Options 42 Example: Synthetics 42 Other Debt Sources 43 Managing a Leveraged Portfolio 44 Portfolio Sizing 44 Portfolio Allocations 46 Rebalancing with Leverage 50 Dollar Cost Averaging and Liquidity Preference 51 Reinvesting Leveraged Gains 52 Summary 56 CHAPTER 3 Indexing with Synthetics and Futures 59 Asset Allocation 59 Index Portfolio Returns 62 Applying Leverage 63 Holding Synthetic Positions 64 Transaction Costs 67 Expected Returns and Reinvestment 68 Adding Portfolio Volatility 68 Random Scenarios with Monte Carlo 72 Margin Calls 74 Substituting Futures 77 Summary 80 CHAPTER 4 Capturing Index Appreciation with Calls 83 Intuitive Option Pricing 83 Options as Potential Liabilities 84 Strike Prices 86 Time and Volatility 86 Dividends and Interest Rates 87 Following an Option 87 Risk Components of Various Options 89 Capturing Appreciation with Options 90 Daily Cost of Options 91 Volatility Skew 94 Uneven Appreciation 96
Contents vii Option Analysis 98 Marginal Returns Extending Time or Lowering Strike 99 Out-of-the-Money 100 Monthly Returns of Calls 103 More about Volatility 105 Summary 107 CHAPTER 5 Leveraged Covered Calls with Futures 109 Covered Calls as a Source of Income 109 Position Details 110 Expected Strategy Returns 111 Annual Return Backtests 113 VIX Modifications 114 Asset Allocation 117 Additional Analysis 118 Summary 119 CHAPTER 6 Rolling LEAPS Call Options Explained 121 Understanding LEAPS Calls 122 LEAPS by the Greeks 123 One Year Later 125 Rolling LEAPS Forward 127 Roll Cost Prediction 128 Estimating Average Returns 130 Investing Cash Flow 132 Capturing Appreciation 134 Rolling Up 135 Selecting Indexes and Strike Prices 137 Market Drops and Volatility Spikes 139 LEAPS Covered Calls 141 Summary 142 CHAPTER 7 Long-Term Returns Using Rolled LEAPS 145 Strike Price Selection 145 Sector Performance: 1999 to 2006 146 Sector Portfolio Returns 149
viii CONTENTS Rebalancing 153 Higher Performance Portfolios 154 Reinvestment Issues 157 Covered Calls and Mid-Caps 158 Covered Calls with Sectors 159 Summary 160 CHAPTER 8 Long and Short Profits with Call Spreads 163 Understanding Debit Spreads 164 Bull Call Spreads 165 Call Spreads and Appreciation 166 Spreads and Skews 169 Early Exit 170 Staggered Exit 171 Diagonal Call Spreads 173 Long/Short Portfolios from Diagonals 175 Early Exit and Theta 177 Calendar Call Spreads 180 LEAPS Calendar Calls and Early Exits 182 Cycling Investment Gains 182 Reinvestment Strategies 185 Constant Investment and Hybrid 186 Index Regime Change 187 Summary 188 CHAPTER 9 Cycling Earnings Using Spread Positions 191 Short Option Selection 192 Long Option 192 Creating the Diagonal Spread 193 Option Portfolio 195 Cycling Fractional and Fixed 196 Faster Reinvestment 198 Transaction and Spread Costs 200
Contents ix Fast Cycling with Calendars 200 Sample Run 202 Volatility Modeling 203 Weekly Volatility Simulation 204 Weekly Strategy Returns 206 Summary 207 CHAPTER 10 Practical Hedging with Put Spreads 211 About Put Options 212 Selling Puts versus Covered Calls 212 Seller Risk in Pricing 213 Protecting Portfolios 215 Puts, Futures, and Leverage 216 Diversification and Correlation 217 Collared Portfolios 218 Bear Put Spreads and Speed Bumps 219 Bull and Calendar Put Spreads 220 Calendar Put Spread 221 Deep-in-the-Money Calendars and Diagonals 222 Rolling LEAPS Puts 223 Rolling LEAPS Calendar Spread 224 Summary 225 CHAPTER 11 LEAPS Puts and Three Ways to Profit 227 Portfolio Safety Nets 228 Expected Returns and Hedging Analysis 229 Correlated Indexes Using SIMTOOLS 232 Correlated Protected Portfolios 233 LEAPS Calendar Put Spreads 236 LEAPS Calendar Put Portfolios 237 Historical Performance 237 Put Writing with LEAPS 239 Expected Returns 239 Scenarios 241 Summary 245
x CONTENTS CHAPTER 12 Managing the Leveraged Multistrategy Portfolio 247 The Question of Alternative Assets 247 The Solution: Own the Producer 249 ProShares ETF Analysis 250 Multiplier Leverage Effect 252 Learning from Failure 253 Asset Management Overview 255 Security Selection 256 Long and Short Strategy Combination 257 Strategy Selection 259 Minimum Investment Sizes 260 Index Exposure 261 Summary 263 Final Words 263 APPENDIX List of Index ETFs and Futures 265 About the Author 275 Index 277
Preface What if we could borrow money at 5 percent and reinvest it at 10 percent annually for years or even decades? This simple idea proved to be the seed for an ambitious project, a book created to show investors how to use futures and options on index-linked securities to earn very high portfolio returns. After more than a year of writing and research, here is that book. To achieve our goal, we start with the highest performing and most reliable investment available in the marketplace, the index fund. In the past several years, literally hundreds of index-related products have been introduced in the marketplace, most designed to capture a narrow slice of returns in the broad markets and provide investors with the capability to mix and match different funds in order to build custom portfolios. Ironically, this wide variety of investment products creates a security selection problem that is very similar to the one that indexing was created to avoid. In this book, we show exactly why some indexes perform better than others and how to successfully combine products into portfolios that deliver better risk-adjusted returns than Standard & Poor s 500 Index (S&P 500). These index portfolios are the basis of our leveraged portfolios. The next step is to apply leverage, and the most cost-effective way to do this is by using derivatives such as futures and options. With these instruments, it is possible to not only borrow money to invest at a low rate of return, but also, when using options, to implement hedging strategies that help reduce the risk of catastrophic losses. A key difference between this book and others on option trading is that here options positions are used to capture long-term pricing trends rather than short-term market movements. On average, the index rises 10 percent a year, but some years it gains 25 percent and in others it loses 25 percent, and the aim is to develop and present a variety of option strategies that can capture appreciation in volatile conditions across many years. Six chapters are devoted to implementing specific long-term strategies. As a result, this book discusses some options strategies in depth but omits others that would be inappropriate to those goals. The focus is xi
xii PREFACE primarily on long calls and call spreads, LEAPS options, and hedging strategies. Previous exposure to options strategies is definitely helpful, but not required, but a solid understanding of investing and index funds is obligatory, and a facility with Excel is assumed. CHAPTER BY CHAPTER The first and introductory chapter in any book on indexing is usually quite tedious, as it presents material that we ve already encountered in a dozen other similar books, forcing us to skip ahead to the point where we can find something new. Thankfully, for both the reader and the author, this book does not have a chapter like this. Instead we start Chapter 1, Owning the Index, with the story of an ambitious project by the University of Chicago that could be considered the genesis of modern index investing. It goes on to discuss how both active and index investing can work in a semi-efficient market; whether there is momentum or mean reversion in the markets; how to interpret market cycles; why some indexes are designed for low volatility and others for high performance; how, exactly, the small-cap and value premiums deliver results; and what the potential factors could be for a four- or five-factor model. Every effort was made to ensure that the reader including the reader who has studied the index for decades will be treated to new material and different ways of looking at the index. The second chapter, Applying Leverage, covers the use of leverage in investment portfolios. To many people, leverage is a dirty word, associated with excessive greed and devastating financial losses. But realistically, without leverage to provide purchasing power, the price of every asset in the marketplace would be lower. We begin the chapter with a defense of the practice, or at least an explanation, provided during one of the stock market s most difficult periods by none other than Merton Miller, the Nobel Prize winning economist. The first concept covered in Chapter 2 is the leverage ratio, and portfolios are shown that both gain and lose value over time as a result of leverage. Special attention is given to underwater investments, which are investments in which the level of debt is greater than the value of the assets due to falling prices. Sources of portfolio leverage that can be applied to index investments are also introduced, including margin loans, futures contracts, and options. Because the most difficult but most important part of managing a leveraged portfolio is reinvesting and compounding gains, the chapter also examines three different types of reinvestment strategies, and also reviews rebalancing and dollar-cost-averaging techniques that incorporate leverage.
Preface xiii Chapter 3, Indexing with Synthetics and Futures, is the first strategy chapter of the book, and shows how to build a leveraged diversified indexbased portfolio with synthetics, which are options positions that replicate a leveraged stock or index position. By holding options on four different indexes, an investor can earn annual returns of 15 percent with decreasing leverage, but with some initial risk of margin calls. Next, we show how to substitute futures to reduce the margin risk and ramp up the leverage to get higher returns. Chapter 4, Capturing Index Appreciation with Calls, begins with an intuitive approach to options pricing that can help investors understand exactly why an option is priced at a certain level, and how to pair the right option with a specific strategy. Next, the Black-Scholes model is introduced and applied to a number of index call options in an effort to determine which ones are best at capturing appreciation and what returns can be expected. A useful piece of analysis is found at the end of the chapter: a historical comparison is made between the closing level of the VIX and the volatility experienced during the next week, and during the next thirteen weeks. We show that the VIX is not a useful predictor of return, but is an important predictor of future volatility, with some caveats. Chapter 5, another strategy chapter, builds a leveraged covered call portfolio using short options and long futures. Covered calls have a fascinating risk-reward relationship and can often provide risk-adjusted returns significantly higher than those of long-only portfolios, which makes them an excellent candidate for leverage. At maximum leverage, the covered call portfolio is capable of losing more than its total investment, and the chapter focuses not only on leverage ratios and asset allocation, but also introduces a possible adjustment using the VIX and the research discussed above that can act as a market timing mechanism and reduce potential losses from the strategy. Chapters 6 and 7 are related to a specific strategy, Rolling LEAPS Call Options. Chapter 6 shows how to use LEAPS call options to create a leveraged long-term position on the index by rolling the option over again and again for many years. During that time, the underlying asset appreciates and the roll forward costs decline, building large amounts of equity and multiyear annual returns in the 15 to 20 percent range. Rolling LEAPS call options is one of the most predictable leveraged strategies, in that all of the cash outflows can be calculated to a relatively high degree of precision. This makes budgeting very easy and reduces much of the risk associated with reinvestment. In Chapter 7, we model the Rolling LEAPS Call Option strategy during one of the market s worst periods and see the results. Then, we use various rebalancing and reinvestment strategies in order to raise the level of return.